Toying with business cycle dating

In this year´s ASSA Annual Meeting in January, Christina & David Romer (R&R) presented “NBER Business Cycle Dating: Retrospect and Prospect”:

“…Our most substantial proposal is that the NBER continue this evolution by modifying its definition of a recession to emphasize increases in economic slack [Deviations from potential output and/or unemployment] rather than declines in economic activity…”

“…Throughout the paper, we make use of Hamilton´s (1989) Markov switching model as a framework for investigating and assessing the NBER dates. Though judgement will surely never be (and should not be) eliminated from the NBER business cycle dating process, it is useful to see what standard statistical analysis suggests and can contribute.”

On page 32, they move to Application: The implications of a two-regime model using slack for dating US business cycle since 1949:

“We have argued that a two-regime model provides insights into short-run fluctuations. And we have argued for potentially refining the definition of a recession to emphasize large and rapid increases in economic slack rather than declines in economic activity. Here, we combine the two approaches by applying Hamilton´s two-regime model to estimates of slack and exploring the implications for the dating of postwar recessions.”

According to R&R (page 34):

“The largest disagreement between the two regimes estimates using slack and the NBER occurs at the start of the Great Recession. The NBER identifies both 2008Q1 and 2008Q2 as part of the recession (with the peak occurring in 2007Q4), while our estimates (see table 1) put the probability of recession as just 21% in 2008Q1 and 43% in 2008Q2.”

Table 1 Economic Performance going into the Great Recession

Quarter NBER Date

In Recession?

Agreement of 2-Regime Model Shortfall of GDP from Potential Unemployment minus Nat Rate
2007Q4 No 97% -0.6% 0.6%
2008Q1 Yes 21% 4.2% 0.9%
2008Q2 Yes 43% -0.2% 1.4%
2008Q3 Yes 91% 3.9% 2.7%

It is somewhat confusing! The 2-Regime model only “fully” agrees with the NBER that the economy was in a recession from 200Q3. The GDP gap roams all over the place, while the unemployment gap is increasing consistently over time.

Although R&R suggest the NBER emphasize measures of slack, those measures are very imprecise. This is clear given the CBO systematic revisions of potential output in the chart below.

Since I´m “toying” with dates, I´ll try using the NGDP Level target yardstick to see what it says about the Great Recession. (Useful recent primers on Nominal GDP Level Targeting are David Beckworth and Steve Ambler).

In the years preceding the Great Recession, there were many things happening. There was the oil shock that began in 2004 and gathered force in subsequent years. There was the bursting of the house price bubble that peaked in mid-2006 and, from early 2007, the problems with the financial system began, first affecting mortgage finance houses but soon extending to banks, culminating in the Lehmann fiasco ofSeptember 2008.

The next chart  the oil and house price shocks.

The predictable effect of an oil (or supply) shock is to reduce the real growth rate and increase inflation (at least that of the headline variety). The charts indicate that was what happened.

The chart below shows that when real growth fell due to the supply shock, real output (RGDP) dropped below the long-term trend (“potential”?). Does this mean the economy is in a recession? If that were true, the recession would have begun in 2006!

In that situation, how should monetary policy behave? Bernanke was quite aware of this problem. Ten years before, for example, Bernanke et al published Systematic Monetary Policy and the Effects of Oil Price Shocks”. (1997)

In the conclusion, they state:

“Substantively, our results suggest that an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy. This finding may help to explain the apparently large effects of oil price changes found by Hamilton and many others.”

In the chart below, we observe that during his first two years as Chair, Bernanke seems to have “listened to himself” because NGDP remained very close to the target level path all the way through the end of 2007.

With NGDP kept on target, the effects of the supply shock are “optimized”. Headline inflation, as we saw previously will rise, but if there is little or no change in NGDP growth, core measures of inflation will remain contained.

During the first quarter of 2008, NGDP was somewhat constrained. This likely reflects the FOMC´s worries with inflation. RGDP growth dropped further, but during the second quarter of 2008, the Fed seemed to be trying to get NGDP back to trend. RGDP growth responded as expected and core inflation remained subdued.

At that point, June 2008, it appears Bernanke reverted to focus almost singly on inflation, maybe remembering what he had written 81/2 years before in What Happens when Greenspan is gone? (Jan 2000):

“U .S. monetary policy has been remarkably successful during Alan Greenspan’s 121/2 years as Federal Reserve chairman. But although President Clinton yesterday reappointed the 73-year-old Mr. Greenspan to a new term ending in 2004, the chairman will not be around forever. To ensure that monetary policy stays on track after Mr. Greenspan, the Fed should be thinking through its approach to monetary policy now. The Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue; even if future Fed chairmen are less skillful or less committed to price stability than Mr. Greenspan has been.

We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation; the source of the Fed’s current great performance; but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system.”

This is evident in his summary of the FOMC Meeting June 2008 (page 97), where Bernanke says:

“My bottom line is that I think the tail risks on the growth and financial side have moderated. I do think, however, that they remain significant. We cannot ignore them. I’m also becoming concerned about the inflation side, and I think our rhetoric, our statement, and our body language at this point need to reflect that concern. We need to begin to prepare ourselves to respond through policy to the inflation risk; but we need to pick our moment, and we cannot be halfhearted. When the time comes, we need to make that decision and move that way because a halfhearted approach is going to give us the worst of both worlds. It’s going to give us financial stress without any benefits on inflation. So we have a very difficult problem here, and we are going to have to work together cooperatively to achieve what we want to achieve.”

From that point on, things derailed and a recession becomes clear in the data. It appears the NGDP Level Targeting framework agrees with Hamilton´s 2-regime model that the recession was a fixture of 2008Q3.

If NGDP had not begun to tank in 2008Q3, a recession might, later, have been called before 2008Q3, but it would never have been dubbed “Great”, more likely being short & shallow.

The takeaway, I believe, is that the usual blames placed on the bursting of the house price bubble, which led to the GFC and then to the GR is misplaced. Central banks love that narrative because it makes them the “guys who saved the day” (avoided another GD) when, in fact, they were the main culprits!

PS: The “guiltless” Fed is not a new thing. Back in 1937, John Williams (no relation to the New York Fed namesake), Chief-Economist of the Fed, Board Member and professor at Harvard (so unimpeachable qualifications, said about the 1937 downturn:

If action is taken now it will be rationalized that, in the event of recovery, the action was what was needed and the System was the cause of the downturn. It makes a bad record and confused thinking. I am convinced that the thing is primarily non-monetary and I would like to see it through on that ground. There is no good reason now for a major depression and that being the case there is a good chance of a non-monetary program working out and I would rather not muddy the record with action that might be misinterpreted.

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.

Contra Nick Xenophon´s idea

The Conversation is critical, but for the wrong reasons:

In the revolving door of economic ideas, the old can be suddenly new again. Independent Senator Nick Xenophon resurrected one such idea this week. He said the Reserve Bank of Australia should replace its inflation target of 2-3% per annum with a target of nominal GDP growth of around 5.5% per annum.


One big problem with Xenophon’s idea is that the theory does not fit the times. It is not the right policy for today.

Energy prices are not going up; they have been falling and are now flat. Yes, electricity prices have been going through the roof in South Australia and to a lesser extent elsewhere. But oil prices have been falling or flat over recent years, and this has a more pervasive effect than government bungling of the electricity market.

So output growth and inflation are not moving in opposite directions – both have fallen in recent years. Inflation is now below the bottom of the RBA’s target zone of 2-3% on any of the alternative measures.

The RBA, along with most central banks of advanced countries, would actually like to see more inflation, not less. Annual output growth is struggling to reach 3%, which is below the long run average of 3.5%. Hence nominal GDP growth is below the 5.5% long-run average that Xenophon would target. So whether the RBA targets inflation or nominal GDP growth doesn’t matter – the policy would be the same – that is, stimulate spending by lowering interest rates, which is exactly what it has been doing.

Why does The Conversation think NGDP targeting is only useful when (real) growth and inflation are moving in opposite directions? That is, when the economy is buffeted by a supply shock. Inflation targeting entices the wrong policy from the central bank, “instructing” it to tighten. NGDP targeting “instructs” the central bank to “ignore it” – good move.

But, more generally, NGDP targeting (in fact NGDP LEVEL Targeting) is the appropriate framework for “all seasons”. In addition to keeping the central bank from mishandling supply shocks, it keeps the central bank from generating demand shocks, which throws both inflation and real growth in the same direction, up as during the “Great Inflation” and down as in the “Great Recession”.

The last highlighted sentence from The Conversation is just confirmation that what is required is a LEVEL target. For example, if the central bank adopted a Price Level Target it would not be in the “low inflation-low real growth” it is in today. The downside of PLT is that just as in the case of IT, the central bank would be tricked into taking the wrong action when the economy is hit by supply shocks.

Another wrong take (among others) of The Conversation is this:

Another downside is that although nominal GDP growth would be more stable, inflation would tend to be more volatile. Inflation could jump up and down, but as long as output growth moved in the opposite direction the RBA would do nothing to dampen the volatility in inflation. Volatile inflation increases the uncertainty about future prices, which inhibits investment spending by firms and households.

As the “experience” of many countries (US,UK, Australia, for example) with implicit NGDP Level Targeting showed, what NGDP-LT provides is Nominal Stability. As Nick Xenophon puts in his “comments on critics” (see comment here):

How does someone who starts a business – taking out a loan and hiring staff – in expectation of 7 per cent a year growth in nominal spending deal with a sudden drop in spending to 2 per cent? Not well, I reckon.

How not to propose NGDP Targeting

Stephen King (not the popular author) but HSBC’s senior economic adviser, elaborates on Larry Summers´ comments on San Francisco Fed president John Williams´ letter. King´s conclusion, however, in effect disparages the idea of NGDP Targeting. Maybe he doesn´t understand the concept:

In these circumstances, the entire monetary policy framework is up for grabs. Shibboleths will have to be dispensed with. At zero rates, central banks may have to work increasingly closely with finance ministries, prioritising the need for co-ordinated action over the desire for independence. Inflation targeting may have to be ditched, perhaps replaced by nominal gross domestic product targeting: a slowdown in real growth would then be countered by a commitment to higher inflation, boosting nominal GDP and limiting the risk of ever more indigestible debt.

Yet nominal GDP targeting will work only if central banks can credibly demonstrate not just their desire for higher inflation but also their ability to deliver it. To date, they have not been particularly successful. And if productivity growth is permanently lower, expectations of a life of ever-rising prosperity will have to be abandoned. If the economics are already difficult, the politics will be considerably harder.

Characterizing NGDP Targeting as a framework in which a slowdown in real growth has to be countered by a commitment to higher inflation is a confused idea. A real growth slowdown may be the result of a negative demand shock or of a negative supply shock. In the former situation, inflation will also fall. In the latter it will rise.

If the central bank is focused on delivering Nominal Stability (which NGDP Targeting, level targeting does provide), drops in real growth resulting from monetary shocks will be avoided, while supply shocks will be “ignored”. Actually, the fact that the Bernanke Fed was so focused on the inflation from the rise in oil/commodity prices was its downfall. In that sense, you could say the Fed is flexible in allowing the (temporary) rise in inflation following a supply shock, but to say it has to be “committed” to it is pure nonsense.

The charts provide a visual history of the economy´s nominal and real growth and inflation.

How not to propose NGDP Targeting

The first thing to notice is that an inflation process (1970s) is characterized by increases in both headline and core measures. This was true in the 1970s and it was made possible by the up trending NGDP growth.

Instances of oil shocks (red dots) are associated with increases in inflation (both Headline & Core) and recessions in the 1970s, but in the 2003-05 and 2007-08 oil shocks, only headline inflation shows a modest increase. The reason for the very different outcomes can be found in the contrasting behavior of monetary policy: very expansionary in the 1970s (up trending NGDP growth) and “stable” in the 2000s.

Volcker´s first attempt at reducing inflation in early 1980 was unsuccessful. His second attempt in late 1981, characterized by a strong monetary contraction (steep drop in NGDP growth) was a success. The important thing to note is the healthy bounce back in real output growth after the deep 1981/82 recession while inflation kept falling.

As soon as he took the Fed´s helm in early 2006, Bernanke showed concern with inflation. With the second leg of the oil price rise in 2007, the concern became an obsession. Monetary policy (NGDP growth) began to tighten and in mid-2008 the brakes were pressed hard. The aftermath, which shows a complete absence of real output bounce back, has kept the economy depressed (or in a state of “Great Stagnation”).

The “Great Moderation” is strong evidence of the benefit of having nominal stability, a situation where the central bank is successful in keeping NGDP growth on a stable (stationary) path. That is the result of the CB offsetting changes in velocity by opposite changes in the money supply.

Note that, by not explicitly targeting NGDP, in 2001-2003, the Fed inadvertently tightened monetary policy. After mid-2003 this error was corrected, with NGDP growth moving back to the stationary path. The Bernanke Fed quickly changed the (effective) monetary policy framework to one first effectively and then explicitly based on inflation targeting. Lately, with inflation persistently below target and “zero” policy rate, the monetary policy framework has become one geared to policy (rate) “normalization”. The manifest failure of this framework has lately been a topic of discussion at the Fed, with John Williams letter being one example.

However, if you pay attention to NGDP growth, you immediately conclude that both the lackluster recovery and low inflation are the natural consequence of excessively tight monetary policy, or too low NGDP growth. This could be “cured” by the adoption of an explicit NGDP Level Target monetary policy framework.

PS The resistance in abandoning the IT framework is strong. This piece by Greg Ip “The Case for Raising the Fed’s Inflation Target”  attests.


Is there an NGDP Targeting bandwagon rolling here? Maybe

A James Alexander post

As recently as the late July John Williams, “an influential centrist” FOMC member and President of the San Francisco Fed, was mouthing the usual threats that have become so common about implementing more rate rises than the market expects:

“The Federal Reserve could raise interest rates up to two times before year end, a top Fed official said on Friday as he downplayed data that showed the U.S. economy grew far less than expected in the last quarter.”

Since then we have had a flurry of comments and speeches suggesting the Fed was engaged in a re-think of its monetary policy. Heck, as we said yesterday, just look a the title of the upcoming Jackson Hole Symposium: Designing Resilient Monetary Policy Frameworks for the Future  .

Now President Williams in a sort of official blog post seems to have completely changed his tune:

“Second, inflation targeting could be replaced by a flexible price-level or nominal GDP targeting framework, where the central bank targets a steadily growing level of prices or nominal GDP, rather than the rate of inflation. These approaches have a number of potential advantages over standard inflation targeting. For one, they may be better suited to periods when the lower bound constrains interest rates because they automatically deliver the “lower for longer” policy prescription the situation calls for (Eggertsson and Woodford 2003).

In addition, nominal GDP targeting has a built-in protection against debt deflation (Koenig 2013, Sheedy 2014). Finally, in a nominal GDP targeting regime, a decline in r-star caused by slower trend growth automatically leads to a higher rate of trend inflation, providing a larger buffer to respond to economic downturns. Of course, these approaches also have potential disadvantages and must be carefully scrutinized when considering their relative costs and benefits.

In stressing the need to study and consider new approaches to fiscal and monetary policy, I am not advocating an abrupt reversal of course; after all, you don’t change horses in the middle of a stream. And in monetary policy, “abrupt” and “disrupt” have more than merely resonance of sound in common. But now is the time for experts and policymakers around the world to carefully investigate the pros and cons of these proposals.”

It’s a shame he doesn’t mention Scott Sumner, the tireless campaigner for NGDP Targeting, but the blogosphere knows where the idea has come from even if a Federal Reserve President can’t be open about the fact.

But a Federal Reserve President who concludes by quoting Machiavelli probably knows a lot more about successful politicking than a mere blogger once of Bentley University.

“Conclusion – Economics rarely has the benefit of a crystal ball. But in this case, we are seeing the future now and have the opportunity to prepare for the challenges related to persistently low natural real rates of interest. Thoroughly reviewing the key aspects of inflation targeting is certainly necessary, and could go a long way towards mitigating the obstructions posed by low r-star. But that is where monetary policy meets the boundaries of its influence. We’ve come to the point on the path where central banks must share responsibilities. There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability.

Policymakers don’t often cite Machiavelli, but in this instance, the analogy is potent (and, perhaps, a portent). In The Prince, fortune is compared to a river; in times of turbulence it wreaks havoc, flooding and destroying everything in its way. But in calm and sedate weather, people can build dams and stem the tide of destruction. In other words, we can wait for the next storm and hope for better outcomes or prepare for them now and be ready.”

Yesterday we said that there had been little obvious reaction in markets. Well, today there has been a little more. Specifically in the USD, which weakened overnight on the back of the “influential centrist” changing his views. Bond markets do not agree as the yield curve remains flat and low. Bonds seem to be responding more to a perception of incipient economic weakness than a revolution in monetary policy. As true Market Monetarists will only know there has been a revolution when the Fisher effect (aka expectations effect) swamps the liquidity effect as bond prices crash in anticipation of higher nominal GDP growth.

“Join the dots”

A James Alexander post

Call me a conspiracy theorist but when three unrelated beasts of the global financial establishment all start talking about the same, previously unfashionable, thing it’s a bit of a coincidence. Maybe Larry’s put it in the agenda of next week’s G20? If it’s not, it should be.

George Osborne:

The MPC have revised down their forecast for real GDP growth and CPI inflation in the short term, implying weaker nominal growth. This, combined with threats from the international environment, mean we face the risk of a weaker outlook for nominal GDP. If realised this could present challenges for tax receipts in the future, and reinforces the importance of delivering our plan to achieve a surplus on the public finances by the end of the Parliament.

Bank of America Merrill Lynch:

3. Cut rates back to near-zero and strong guidanceif the equity market drops into a full bear market (or there is some other equivalent financial tightening) or if growth seems to be slowing to a sustained 1%, the Fed would likely cut and remain on hold until the financial/economic weakness reverses. They could introduce a nominal income growth target or price level target to signal an accommodative path for rates well into the future.

Larry Summers:

But monetary-policy makers need to acknowledge much more explicitly that neutral real rates have fallen substantially and that the task now is to adjust policy accordingly. This could include setting targets for nominal GDP growth rather than inflation, investing in a wider range of risk assets, making plans to allow base rates to turn negative, and underscoring the importance of avoiding a new recession.

A UK case against NGDP Targeting turns mostly on the alleged quality of the data

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.

A French assessment of NGDP Targeting misses the point

A James Alexander post  

A few days ago we contrasted the bad news of Draghi disappointing markets after the December ECB Board meeting with the good news of the growing debate on NGDP Targeting in the Europe. We noted that the Committee on Economic and Monetary Affairs of the European Parliament held a session on NGDP Targeting. One of the papers they commissioned was very positive, while the other two were somewhat critical of the idea. It is worth taking a look at the work of the sceptics in turn.

A view from France:

The French paper was by three academics, Christophe BLOT, Jérôme CREEL and Xavier RAGOT, from the influential OFCE/Science Po in Paris.

The paper starts with a review of the literature on Inflation Targeting and says things went well until the crisis. A caveat they mention is that since both IT regimes and non-IT regimes did well in bringing down inflation it is really too hard to tell if IT was all that superior.

We think it is also very hard to tell apart exactly what regimes are doing from what they say they are doing. The paper says that:

The Bank of England is, for example, a “pure” inflation targeter, whereas [the] ECB has not adopted this regime, although with its price stability objective, it is close to [it].

The evidence would surely suggest that the BoE was actually pretty flexible in all but the last 18 months or so, and in fact its Deputy Governor for Monetary Policy showed recently the UK central bank was actually targeting RGDP in its interest rate decisions. Very confusing.

To be fair the French authors cite:

[T]he outcome of Creel and Hubert (2015) [that] suggests that inflation targeting countries which have adopted the IT framework have not over-emphasize[d] inflation deviations from target like “inflation nutters” to take the words of King (1997).

Ironically, Mervyn King was probably a “nutter”, but not an “inflation nutter”. He became so obsessed with not being seen to bail out banks in the crisis that he ignored both high headline inflation (good) and collapsing nominal growth expectations (tragic).

If anyone should be labelled an “inflation nutter” it should probably be Jean-Claude Trichet. He was the ECB President who aggressively raised rates in both 2008 and 2011, unique among major central banks. These moves condemned the Euro Area to the most prolonged, double-dip, recession of any major monetary area. The authors seem to have missed this, but then so have most  mainstream European macroeconomists, for the moment.

To be fair again, the authors do at least address criticism of IT and do ask the right question:

The advent of the global financial crisis has certainly revived criticism against IT. Contrary to what had been long taken for granted (see Blot et al., 2015), the objective of price stability has not showed a unique relationship with financial stability. Stated differently, price stability has not produced financial stability.

A slight understatement there, the lack of a “unique relationship”.

Frappa and Mésonnier (2010) have notably suggested that house prices increases have been higher for countries adopting IT regimes than for non-IT countries.

Is this the authors´ only criterion for financial stability, house price increases?  Then they go on:

Does this mean that IT has been responsible for the crisis? The empirical literature discussed above shows that the performance of IT countries has not been worse than non-IT countries. In this respect, IT would not be a specific “perpetrator” of the crisis (see the introduction of Reichlin and Baldwin, 2013). Moreover, the anchoring of expectations that IT or IT-like monetary policies (e.g. ECB policies) have performed has been unanimously praised (Gillitzer and Simon, 2015). Finally, Fazio et al. (2015) suggest that banks in countries which have adopted IT regime are more stable and seem to be less vulnerable to global liquidity shocks.

This rather strange result appears to be because Fazio et al seem to be judging IT on its success in not creating bubbles rather than creating crashes. Fazio et al is therefore like the authors who think the crisis was, at least partly, caused by house price bubbles. There seems to have been no consideration of obsession with inflation, “à la Trichet”, causing tough monetary tightening at just the moments it needed to be loosened. It seems to have been ruled out a priori.

In fact, both IT and the ECB have been “unanimously praised” for anchoring inflation expectations, and only judged on this. Moreover, it is probably true. However, this judgement ignores that it’s been a very heavy anchor, dragging down the ship of the economy into double-dip recession. And now, in any case, actually de-anchoring those expectations on the downside.

With these searing experiences within the Euro Area over the last seven years, the authors rather incredibly, claim that:

IT regimes have generally not overlooked output performance (and notably the output gap) either because such a variable can be seen as a leading indicator of future inflation or because central bankers also care about growth and employment performance and consider that monetary policy may help to stabilize the output, at least in the short term.

And so there is no need to formally adopt NGDP Targeting since they already do it informally.

“There’s none so blind as them that can’t see”, as we say in Northern England.

The paper then lists three arguments for NGDP Targeting:

  1. It allows for an immediate monetary stimulus in the current deflationary environment.
  2. It is good at coping with supply shocks, like productivity improvements, if the real effect were more important than the inflation effect.
  3. It would help prevent crises caused by rising debt to gdp ratios in a deflationary environment.

There is a bit more to NGDP Targeting than these points, but we will let that be for now.

The paper then lists five drawbacks of NGDP Targeting. We summarise and reply.

  1. It is close to flexible inflation-targeting, so not necessary.

The problem with flexible inflation-targeting is that it allows too much discretion, and trusts central bankers are sagacious enough not to be distracted by volatile inflation, something in which the ECB miserably failed.

  1. Level-targeting would create confusion if rational expectations were not shared by the central bank and the public.

The public only really want stability of nominal growth. They don’t really understand inflation. Even if they can sense prices rising in certain parts of their shopping basket they struggle with the total figure and they and statisticians struggle with actual rents, imputed rents, hedonic adjustments, changes in mix and the price of services, to name just six very tricky areas. CPI just isn’t an easy concept at all. They especially don’t understand real growth.

But money illusion is real. The public understands nominal growth in income, and rightly fear job losses when nominal growth goes negative. That is the most important point of all: central banks must prevent too slow or negative nominal growth. All else is noise. And we just have to assume central banks will be rational in future when they have a proper plan like NGDP Targeting, even if in the past they have caused massive damage with their discretionary monetary policies.

  1. Nominal GDP has no tangible content for the public whereas the CPI does. And NGDP is revised constantly, too.

NGDP is measured in three ways, output, expenditure and income, and they equal each other. The public certainly understands nominal income, their take home wage packet and how it grows. Obviously, the output method is more difficult to understand but that is irrelevant, it’s just another way of  accounting for the same thing.

The NGDP revisions criticism is a red herring, partly as bygones are always bygones, partly because the key point of Market Monetarism is to work on expectations of NGDP growth, not the rear-view mirror numbers – just like the central banks claim they work with CPI expectations more than the rear-view numbers. The fact that many countries CPI numbers are not revised means they are not proper economic statistics and therefore an unreliable record of the past and should not be targeted in the future either. No proper macro economic statistics can be perfect first time. The fact that the GDP Deflator gets revised means it is a far more reliable piece of data than CPI.

4 . The composition of NGDP between inflation and real growth may be a social target and not to be set by the market. [I think this is what the authors mean.]

The only answer is, yes, governments may well want to try and alter this balance through fiscal or other policy. But they would surely have just as much of a challenge as doing it via management of CPI and RGDP separately.

  1. Central banks should not only look at monetary stability but financial stability.

This is not an argument against NGDP Targeting per se, but against any pure focus on monetary policy.  Some NGDP Targeters argue for completely separating monetary policy from marco-prudential policy, others see this as impossible. It doesn’t make NGDP Targeting any less plausible.

The authors then run a model that shows that flexible inflation-targeting worked as well as NGDP Targeting. It should be expected that perfectly operated Flexible IT would work well, but it rather begs the question about practice. The problem isn’t so much with the theory of Flexible IT but the practice.

Still, it’s good the authors have addressed the issues if not covered themselves in glory in their analysis. Especially lacking is a long, hard self-examination of the ECB in its own IT regime in practice in 2008 and 2011.

UK Socialists show interest in NGDP Targeting, BoE proxy moans

A James Alexander post

Scott Sumner is both warming up to Bernie Sanders and getting excited by growing signs of acceptance for Market Monetarism. In the UK we seem to be getting both things in the one package.

Writing in the Financial Times our new, “hard-left socialist”, senior opposition spokesman on finance, Shadow Chancellor of the Exchequer John McDonnell, has said he is interested in NGDP Targeting.

McDonnell has created a group of leading, if left-leaning. macro-economists to advise him on macro-economic policy. Their first job is to lead a review of the Inflation Targeting mandate of the Bank of England. The group includes many names familiar to Market Monetarists like Adam Posen, David Blanchflower and Simon Wren-Lewis. We know them because of their willingness to debate about NGDP Targeting and even broadly accept it as at least partially useful – though they all prefer active fiscal policy at the ZLB over what they consider to be unconventional monetary policy.

“The last time the Treasury tweaked the MPC’s remit was in 2013, when George Osborne, chancellor, clarified that the committee need not force inflation back to the target by the fastest possible route if a slower one would be better for growth. We will consider whether such trade-offs should be formalised. And we will look at more radical ideas, such as introducing a target for nominal gross domestic product — a suggestion Mr Carney broached in 2012.”

This is great news.

The diehards at the Bank of England won’t like it. An initial response from one of the leading UK economist who often represents mainstream BoE views was distinctly lukewarm.

Tony Yates even addressed himself to the NGDP Targeting idea:

“I’ve blogged a lot about this before, and haven’t the heart to repeat it here.  Very briefly.  Growth targets would not make a whole lot of difference.  Levels targets rely on being a rational expectations nutcase, and even then would probably be incredible.”

The attack on Rational Expectations is the oddest thing. It’s not clear what his problem with RE really is. It’s very hard to figure out. Yates is clearly a clever guy, but like most central bankers and their supporters, they distrust markets and prefer discretion. Yates seems to think that elite central bankers sitting around a table with lots of different models, lots of data and super-smart intuition is better than clear rules. We only need to ask how that worked out in 2008 to see what was wrong: internal politics, confusion and hopeless or downright counter-productive signalling. To recognise that central bankers were the prime cause of the recession is a step too far for the self-same central bankers and their proxies.

From an earlier anti-NGDP Targeting piece Yates demonstrates clearly the knots he ends up tying himself in when thinking about RE:

“Policymakers at the BoE used an RE model, but when they thought it was relevant, would often adjust forecast profiles by hand afterwards to try to offset what they thought were the effects of rational expectations.  (Highly unscientific and hopelessly imprecise in doing it this way, but well-intended).  However, whether central banks assume RE or not, it’s not a good defence of a regime that it works well in a false world those central banks happen to believe in.”

Who’s the nutcase?

Update. Excellent blog from Ben Southwood at the Adam Smith Institute.

NGDP not less reliable than RGDP (or inflation), but it’s not relevant anyway

A James Alexander post

There is growing debate about the potential introduction of NGDP targeting or, rather, a debate that had quietened down seems to building up steam again in Europe  and in the press.

Back in 2012 it was discussed in central bank circles. This was probably due to the recovery seemingly stalling in many countries and central banks were reluctant to do more QE and cast about for alternatives.

As the global recovery began to pick up in 2013 the NGDP train itself thus stalled. In the UK semi-secret discussions led nowhere and some semi-public inquiries opted for the status quo. The cloak and dagger nature of the debates was because of the sensitivity of the subject, evidenced by the wonderfully positive response to Mark Carney raising the issue when he was still head of the Bank of Canada, but on his way to the Bank of England.

The major confusion about the actual target of monetary policy and the direction of US and UK interest rates has brought NGDP targeting back on the agenda. Headline inflation, core inflation and the central bankers’ preferred measure of the GDP deflator, are all flat on their backs. Long term market-implied inflation, or as the Fed likes to belittle it “inflation compensation” (ie the US TIPS spread) is also very low. Why not look at NGDP expectations instead?

The weakest criticism of NGDP Targeting

A lot of the smart set like to dismiss NGDP because they think it gets revised a lot more than RGDP or inflation. This is simply false for the US as I showed here.

In any case it is theoretically impossible for NGDP to be revised more than RGDP, given equal resources to the production of the data. RGDP is merely a derivative of NGDP deflated by inflation, another set of data that is prone to revision, as shown for the US by Mark Sadowski here.

Yesterday’s revisions to UK GDP by the Office for National Statistics provided an opportunity to do a similar test of RGDP vs NGDP revisions. It’s a bit hard to compare apples with apples as UK RGDP estimates bizarrely come out in what the ONS calls Month 1 (M1), 3-4 weeks after the quarter end, while NGDP only comes out in Month 2 (M2) with the first revisions of RGDP. There is then a Month 3 final release. However, there are also at least three further reviews “Blue Book 1” (BB1) after a year and “BB2” after two years, plus a more final review after a period of 3 years (Y3). Yesterday’s revisions showed some very large changes to the history of RGDP,  in particular for the 2012 quarters.

Looking over a long period the quarterly YoY revisions for the UK come out like this:

JA NGDP Revisions_1

The revisions more or less cancel themselves out over long periods. The UK RGDP and NGDP has been shown to be much worse than first feared during the Great Recession, but the recovery has been shown to be more robust too.

The average revision excluding the direction of the revision is somewhat greater for NGDP than for RGDP, although the Standard Deviations aren’t that different.

So much for NGDP being far worse than RGDP for revisions, and with equal work they will be smaller revisions.

Inflation: CPI, RPI or the GDP Deflator?

Some have pointed out that inflation in the UK never gets revised, but this is just the Consumer Price Index and its predecessor, the Retal Prices Index. The “no revision” stance is a political one, not a statistical one. And something so political should not be an object of serious monetary policy, or even serious economic research. The ONS themselves more or less admit this:

Consumer price inflation statistics are important indicators of how the UK economy is performing. They are used in many ways by individuals, government, businesses, and academics. Inflation statistics impact on everyone in some way as they affect interest rates, tax allowances, benefits, pensions, savings rates, maintenance contracts and many other payments.

 “The uses to which consumer price inflation statistics are put (notably indexation) means that it is imperative that every effort is made to ensure all data are included in the first release of any month’s figures. This is reflected in the revisions policies below.

“CPI indices are revisable although the only time the CPI all items index has been revised was when the index was re-referenced to 2005=100, which took place with the publication of the January 2006 indices.

And the Retail Prices Index before it:

The policy for the RPI is that once the indices are published they are never revised. This was re-affirmed in the 1986 RPI Advisory Committee report (Command 9848 p86, para 183) which states:

“it has always been the practice not to revise the RPI once it has been published, as doing so would create serious problems for some users, particularly in connection with index-linking, and we have no wish to see this practice changed.”

There are no perfect macro indices. The notion that it is a political stable index is shown by the number and size of revisions to the GDP deflator, the professional central bankers measure of choice.

The ONS also helpfully released its “revision triangles” for the GDP deflator this week which make a colourful chart that reveals some incredibly wild revisions to the GDP deflator from any particular quarter. Many are revised by quite substantial amounts several years after the initial releases.

The lines in the chart show the “life” of each YoY quarterly deflator, from birth a few weeks after the period end to the current day. The most ill-behaved child is the 3q12 deflator, going negative at one point in its 3 year life to date. Not coincidentally, the quarterly RGDP numbers have been ill-behaved too.

The volatile lives of YoY quarterly deflators

JA NGDP Revisions_2

The average revisions for the quarters from 1q00 to 1q06 are 0.1 including the sign, 0.9 excluding the sign with a standard deviation of 0.6. The latter two quite a bit worse than either RGDP or NGDP. So much for NGDP being less reliable than a reliable inflation index.

It is slightly comical, but also deadly serious. Historic data cannot be relied upon. Medium term expectations are what really matters as they drive actual behaviour. People do not drive by looking in the rear view mirror. Steering current and future behaviour is what will avoid recessions and excessive booms.