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.
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.