A James Alexander post
Twitter is great. It gets to the nub of issues quickly. No messing.
Every time I propose NGDP Targeting the heavyweight sophisticates immediately come back like here and here. with “you can’t target that because of the huge revisions”. It got me thinking about what these twitterati would target.
Inflation: anyone’s guess
The inflation target is perhaps the worst of all. There is little agreement about which inflation rate to choose. Rightly so. It’s way more complex than facile economic commentators think.
- Should the rate be the one faced by the average consumer? The average consumer is a tricky concept to start with, as we all know. Perhaps the median consumer?
- Core inflation, excluding volatile items like food and energy? No small debate there! And lives depend on it as central banks often seem to regard high headline inflation inflation as a justification for raising rates, trumping core rates. And then low headline inflation rates are somehow to be ignored and instead a focus on core inflation, or even core inflation expectations a very long way out.
- Housing costs are 30-40% for the average consumer. And they are very sticky. Incorporating “inflation” in those housing costs is immensely tricky, either tracking sticky prices like rent, and of then of course separating out changes to the quantity and quality of what is rented. Or, even worse where there are a lot of homeowners, you need to measure inflation in imputed rent (ie the purely inflationary element of the theoretical benefit homeowners get from owning their homes, again stripping out those pesky quality and mix changes). the UK ONS has been criticised for not measuring housing inflation properly, but it is hard to do.
- Or should expected inflation be used? Perhaps this has the benefit of never needing to be revised. But there are numerous versions of expected inflation. Short, medium and long term. Consumers expectations, business expectations. These are very different in the UK at the moment. Or market-implied expectations? But expectations of what? CPI, RPI, Core CPI, the deflator? And here we have some genuine issues about reliability anyway, as neither the government or the central banks don’t like it they don’t really focus on helping improving the efficiency of this market. The table from the BoE August report illustrates the “pick a number” problem.
A better inflation measure is the deflator, but …
If we really want to improve national well-being we need more output, more wealth, so the inflation rate that really needs to be divined is the output deflator: how we move from nominal value of output to real output, stripping out inflation. Then somehow target not having too much of that sort of inflation.
That deflator is not an easy measure either. The same hedonistic challenges apply, i.e. how does the quality of output change over time. The same mix effect causes huge challenges as economies are both complex and highly dynamic. Eighty percent of most modern economies produce services, not goods. Inflation in service sector output is no easy thing to measure, e.g.
- Housing output from existing houses (10% of a modern economy by value added)?
- Output from the government in terms of schools, hospitals/defence and bureaucrats (about 5% each)?
- Distribution (15% of a modern economy)?
- To say nothing of banking, insurance, legal services, IT, pointless celebrities, etc, etc.
An excellent essay by Geoff Tily of the UK’s ONS demonstrated the challenges of measuring either service sector output and its deflator.
UK CPI is the least reliable measure to target: it’s never even gets revised!
Laughably, in the UK the Consumer Price Index is targeted by the Bank of England. This index is a political and contractual one, as it used to set welfare and pension increases, the return on index-linked bonds, for inflation swaps, and often in wage negotiations. Some clever people think it is reliable because it is never revised. This is a really foolish argument. The lack of revisions demonstrates its political and contractual importance, but also proves it is not a reliable measure of what is happening in the economy. Only economic measures that get revised are reliable as they demonstrate a proper respect to the difficulties of measuring macroeconomic variables. No respectable professional macroeconomist should use it in any model of how the economy works.
Output is the way to go, but expectations not the rear-view mirror
So what about targeting output? Well the clever people spot the problem. It is often revised. Partly due to revisions of the physical output, partly due to revisions of nominal output (by value), partly due to the deflator, partly due to mix changes, methodological changes, even mistakes. Revisions are the output number’s strength, not it’s weakness. It is constantly improved upon, unlike the joke macro number of the UK CPI.
Critics are right that targeting a number that gets revised is a problem, but that is why you should look through the problem and target expectations for the number. If there is a rationale for targeting inflation expectations, it can be applied to output too. Expectations can’t get revised, they are updated, and do influence actual behaviour. If output growth is expected to be robust people will act differently to if they expect it to be poor. Historic price numbers or output numbers are the rear-view mirror. You can’t drive by looking behind you.
There are a host of subsidiary numbers that could be targeted like wages, employment, business surveys etc., but none provides the full picture of a dynamic economy, and are all flawed for that reason. Perhaps nominal wage growth could be targeted as that is at the heart of the problem of macroeconomics, unemployment being caused by downwardly sticky wages during a turndown in aggregate demand. I feel just targeting nominal wages might be a bad thing as it could end up being gamed or rather indexed, but it is worth thinking about.
A word about unemployment targeting
Employment, or rather unemployment, could be targeted. But just look briefly at the almost endless debates about labour force participation rates, especially in the US; about the quality of the employment, especially in the UK; or about the real number of unemployed, especially in countries with large informal economies and easy unemployment registration. Unemployment is not the answer. Perhaps, expectations of unemployment?
Derivatives of output, like output per head, or output per hour (ie productivity) could be targeted but these obviously suffer from the challenge of first measuring real output reliably. In addition, I am not sure how or who would target expectations of output per head or per hour.
Real output or nominal output?
And there is the final measurement challenge. If measuring nominal output is tough and measuring the deflator is tough, measuring a derivative of the two is more than doubly tough (RGDP=NGDP/Deflator).
I know that some chunks of RDGP are measured by measuring actual stuff produced. Officials do gather data on the oil pumped out of the wells, the cars coming off the production line, or bushels of wheat from the farms. But extraction industries, manufacturing and agriculture are a very small fraction of any economy these days – even in an industrial powerhouses like Germany.
So, which output number should be targeted, a real or a nominal one? Both.
- Governments (or rather “society”) should target (be concerned with) real output, the creation of wealth.
- Central banks should target expectations for nominal output (NGDP), i.e. the value of the real output measured in money terms – assuming a steady growth in nominal output is a good thing, which most people do.
The balance between nominal growth and real growth, inflation, can then be left for society to figure out.