The real targets should be nominal targets

A James Alexander post

At first glance the abstract of this brand new research piece, The Macroeconomic Risks of Undesirably Low Inflation, from the Federal Reserve Board sounds rather dry and innocuous:

This paper investigates the macroeconomic risks associated with undesirably low inflation using a medium-sized New Keynesian model. We consider different causes of persistently low inflation, including a downward shift in long-run inflation expectations, a fall in nominal wage growth, and a favorable supply-side shock. We show that the macroeconomic effects of persistently low inflation depend crucially on its underlying cause, as well as on the extent to which monetary policy is constrained by the zero lower bound. Finally, we discuss policy options to mitigate these effects. 

However, the actual contents are rather more exciting. The authors recognise the damaging impact of low inflation and low rates, if the central banks feel trapped by the ZLB and that they therefore see real interest rates driving higher. Market Monetarists believe that there is no ZLB nor a liquidity trap as more can always be done, but at least these researchers clearly recognise the problem [emphasis added]:

Specifically, we begin by considering a fall in long-run inflation expectations below the central bank’s inflation target. Such a development would have minimal effects on output if the central bank was free to adjust policy rates, or at least could do so in the fairly near term. By contrast, a fall in long-run inflation expectations reduces output substantially if the economy is mired in a persistent liquidity trap. This reflects that the fall in long-run inflation expectations boosts real interest rates far out the yield curve, including through extending the duration of the liquidity trap.

On top of the impact of higher real interest rates, they also recognise the damaging impact of lower inflation expectations in turn lowering nominal wage growth and causing further hits to output. Perhaps it is just stating the obvious, but at least they recognise the problem.

While suggestive, this analysis understates the economic costs of a fall in inflation expectations … lower long-term inflation expectations not only depress the mean level of output in a liquidity trap but also intensify downside risks … we show that a deceleration in nominal wage growth due to higher wage flexibility can have sharply contractionary effects on output in a liquidity trap by causing price inflation to fall and real interest rates to rise.

The authors are too bit mealy-mouthed about coming out in favor of price level targeting, because it is somehow against the tradition of being inflation hawks.

We conclude with a brief discussion of how monetary policy can help to alleviate low inflation pressures. An important and influential literature has recommended commitment based strategies such as price level targeting, including e.g., Eggertsson and Woodford (2003). While potentially efficacious, such an approach would involve a substantial departure from the typical focus of central banks on inflation.

Confusingly, their solution is actually to depart even more from a focus on inflation, with a couple of real economy measures. The history of targeting real economy measures is not good, real GDP, the unemployment rate, the output gap. All hit problems, partly because they are dependent on factors that are outside the control of the central bank, like productivity, innovation and structural changes – or just incredibly hard to estimate.

We suggest an alternative in which monetary policy responds to a broad measure of resource slack that includes a state variable – the capital gap in our model, or the labor force participation gap in a model with richer labor market features – that recovers particularly slowly following an economic downturn (see e.g. Erceg and Levin (2014)). Because such a rule causes inflation and output to overshoot as the economy recovers, it boosts longer-term inflation expectations while the economy is still mired in recession, which mitigates the severity of the fall in both inflation and output.

If the goal of these proposed real economy targets is to boost longer term inflation expectations, why not just eliminate the middleman and target higher inflation expectations themselves? Or better still, target nominal growth expectations. Real targets should be nominal targets, just realistically high ones and not capped by 2% inflation projections.

What´s the good having weapons & ammo if you don´t have a target to aim at?

Anatole Kaletsky reviews proposals for central bank action in “Central Bank´s Final Frontier?”:

Have central bankers run out of ammunition in their battle against deflation and unemployment? The answer, many policymakers and economists writing for Project Syndicate agree, is clearly No.

“Monetary policymakers have plenty of weapons and an endless supply of ammunition at their disposal,” says Mojmír Hampl, Vice-Governor of the Czech National Bank. The real issue is not whether more powerful monetary instruments are still available, but whether using them is necessary – or even threatens to do more harm than good.

And he goes on to consider all the different “calibers” of ammo Central Banks have at their disposal, from interest rates, including the negative variety, QE and Helicopter Money (HM), not forgetting the fiscal help that could be extended by the Treasury Departments.

But what is the use of having “weapons & ammo”, be it QE, negative rates or HM, if there is no goal or target to “point and shoot” at?

In other words, if you don´t have a goal or target, i.e. a destination, how can you “steer” the economy?

For the 1990 – 2007 period, the Fed managed to keep NGDP growing quite close to a trend level path. Maybe that was the implicit target. There were misses, sure, but they tended to be corrected and were nothing that compares to what happened in 2008.

Weapons & Ammo_1

Throwing the economy into a recession that became “great” and quickly turned into another (or ‘lesser’) depression was, I believe, the work of extremely bad monetary policy that had become “fanatically concerned” with headline inflation.

Weapons & Ammo_2

All the “ammo”, or “strategies”, adopted and ‘talked about’ have succeeded only in keeping NGDP growing at a rate below the previous trend and have not made any attempt to get NGDP closer to the previous trend level. But that would only be possible if the Fed had an explicit NGDP level target.

Since mid-2014, in fact, it appears that NGDP growth is falling even further behind, which is consistent with the tightening bias the FOMC has shown since the end of QE3 was in sight.

The target the Fed has, the 2% IT, has not only lost credibility but mostly works to constrain any attempt that might be made to get spending up, because the “2% target cannot be breached”!

John Williams cannot think “outside the box”

He can only think in terms of interest rates. Since that´s pegged at “near zero levels” he feels lost:

Policy rules also wouldn’t have done much for the Fed in recent years with interest rates pegged at near zero levels, Mr. Williams said in the text of a speech prepared for delivery before an audience at Chapman University in Orange, Calif. These rules would have argued for something not easily done, and that would have been for the Fed to have pushed short-term rates deeply into negative territory, he said.

Mr. Williams said the problem policy rules have with zero interest rates is probably not over. The use of unconventional policy stimulus like bond buying and other tools “are very likely to occur again in the future,” and rule-based policy-making will have nothing to contribute in such a scenario, he said.

Scott Sumner has just written a post that tries to understand the “stance” of monetary policy, and ends thus:

People are constantly telling me that my “tight money” theory of the 2008 recession is loony.  But I am never provided with any good reasons for this criticism.  I have no doubt that there are hundreds of macroeconomists who are much smarter than I am, but I do occasionally wonder if my profession is somewhat lacking in imagination.

Lack of imagination is exactly what John Williams (and his colleagues) exudes!

Another chapter on “What´s wrong with economics”

Wolfgang Munchau has an interesting piece on the FT: “Macroeconomists need new tools to challenge consensus”:

Macroeconomists are once again caught up in a discussion about the future of their profession. An example has been the recent debate between Lawrence Summers and Ben Bernanke about the deep causes of the economic slowdown. The former US Treasury secretary has defended the case of a “secular stagnation” while the former chairman of the Federal Reserve sees an excess of savings over investment.

It is an enlightened debate, but it also masks a much deeper problem within macroeconomics. Secular stagnation — a sharp fall in growth rates lasting a very long time — is not something that you can easily square with the current generation of macroeconomic theories and models.

Part of this debate reminds me of a discourse among mathematicians at the end of the 19th century. At the time, mathematicians — and physicists too — thought they had solved most problems, just as economists did until 2008.

The advent of chronic instability is the equivalent challenge for macroeconomics today. The present tools used by mainstream macroeconomists cannot deal with this adequately. New ones are needed. They exist in other disciplines, but to macroeconomists they look as weird today as the abstract stuff looked to mathematicians of the 19th century.

Some comments (with reference to the US):

1 I don´t think there is chronic instability. There was a spate of instability in 2008-09, that configured the crisis. For the past five years what we´ve had is a “great stability” at the “wrong level”.

2 The 1970s was a decade of “Great Instability” (“Great Inflation”) in real growth, unemployment and inflation; but that was followed by more than 20 years of “Great Stability” (“Great Moderation”) in real output, unemployment and inflation.

3 The “Great Disturbance” derived from the fact that policymakers, in particular the ones responsible for monetary policy, came to believe that the source of the “Great Stability” was having kept inflation low and stable (or on target). So when inflation got a direct hit from oil prices they “tightened the monetary screws” and reaped a “Great Instability” followed by an “Inadequate Stability”, also dubbed “Secular Stagnation”!

The necessary tools are certainly there. What´s needed is a revision of the mainstream views on the source of the “Great Stability”!

Nick Rowe has a discussion and suggestion:

Fluctuations in inflation are a noisy signal of monetary disequilibrium, because the firms that do change prices are not always representative of the firms that don’t. And by targeting inflation the central bank makes inflation stickier, and this reduces inflation’s signal/noise ratio. Fluctuations in output are also a noisy signal of monetary disequilibrium. NGDP targeting means targeting the sum of two noisy signals. NGDP targeting is unlikely to be exactly optimal, but may well be better than inflation targeting, which puts all the weight on one noisy signal and ignores the other.

The big puzzle of the recent recession is why the inflation guard dogs failed to bark, to warn central banks of recession. Even in those countries where inflation did fall, it only fell a little. In others it stayed on target, or even rose above target. The NGDP guard dogs barked loud and clear, giving a consistent and correct signal. That is what we need to model. And if we can model that, we may also have a model in which targeting NGDP can do better than targeting inflation.

MM Heresy: Is IT Band Targeting Better Then NGDPLT? Unmeasurable Means Unmentionable?

A Benjamin Cole post

Could it be that a looser IT band is a better policy target than NGDPLT?

What if a nation can measure prices and thus relative slack reasonably well, but real-time estimates of even nominal GDP are worsening guesses?

Moreover, what if much of what makes urban life agreeable—better parks, clean air, pleasing sidewalks, good schools, low crime, leisure time—is not even captured by GDP? And the world is going urban.

And then add to the mix the perhaps exploding role of the off-the-books grey markets in the United States, unrecorded?


The amount of cash in circulation in the U.S. has exploded to $4,200 per resident, doubling in the last 10 years. The response of U.S. economists, who obviously never worked in a small business in Los Angeles, is that, “Well, the Benjamin Franklins are all offshore doing drug deals.”

Anyway, Edgar Feige, University of Wisconsin cash-scholar, says 75% of cash is onshore and in grey markets. That $3k for every man, woman, child and transgender in America. And growing rapidly.

As Feige says, “the growth of unreported income has the insidious effect of corrupting the reliability of primary data used for most macroeconomic analysis.”

Unmeasurables And Thus Unmentionables

Measuring GDP? Consider the Los Angeles of 1975 vs. that of 2015. One was a poison gas chamber, a permanent scrim that occluded close neighbors, and the latter has winter air in which one can sight Mt. Baldy 75 miles distant.

Crime rates at record lows, too.

No show on GDP, however.


Surely, a looser NGDPLT target is better than the Fed’s sub-2% monetary IT noose.

But, if the public is un-teachable on NGDPLT (or more likely, the profession), then perhaps taking a page from the Reserve Bank of Australia and its 2% to 3% IT band is a good idea.

Just goose the IT up a bit to 2.5% to 3.5%. There is no sense in permanently losing real growth for some  chump reductions in inflation.