The minutes of the latest Federal Reserve meeting were the subject of intense interest to a subculture of a subculture: those economics bloggers who have advocated that the Fed adopt a policy of stabilizing the growth of nominal gross domestic product. They -- OK, we -- were excited because the minutes show that the Fed is interested in our idea.
True, the Fed ultimately rejected it. But those of us with an optimistic bent take heart in the flimsiness of its reasons for doing so. Perhaps it will take just a little more argument for us to carry the day.
Nominal GDP (NGDP) is simply the size of the economy measured in dollars, with no adjustment for inflation. In a year when the inflation rate is 2 percent and the economy grows by 2 percent in real terms, NGDP rises 4 percent. The NGDP targeters say that the Fed should aim to keep this growth rate steady. Christina Romer, the former chairman of President Barack Obama’s Council of Economic Advisers, suggested in the New York Times recently that NGDP should grow at 4.5 percent a year. If the Fed overshoots one year, it should undershoot the next, and vice-versa, so that long-term NGDP growth stays on target.
Like the more familiar concept of inflation targeting, NGDP targeting seeks to stabilize expectations about the future path of the economy, making it easier for people to make long-term plans. Keeping nominal spending, and thus nominal income, on a relatively predictable path is especially important because most debts, such as mortgages, are contracted in nominal terms. If nominal incomes swing wildly, so does the ability to service those debts.
The chief advantage of targeting NGDP, rather than inflation, is that it distinguishes between shocks to supply and shocks to demand. With either approach, the central bank should respond to a sudden drop in the velocity of money by expanding the money supply. If people are holding on to money balances at a higher rate than usual -- because of a financial panic, just to pick a random example -- both inflation and NGDP would fall below target and the Fed would have to loosen money in response.
But the two approaches counsel opposite responses to a negative supply shock, such as a disruption in oil markets. That shock would tend to increase prices and reduce real economic growth, thus changing the composition of NGDP growth but not its amount. With an NGDP target, the Fed would accordingly leave its policy unchanged. With a strict inflation target, on the other hand, the Fed would tighten money -- and thus the real economy would take a bigger hit from the supply shock.
A positive supply shock, such as an improvement in productivity, would also elicit different responses. Under an NGDP target, the rate of inflation would decrease and real growth would increase. A strict inflation target would force the Fed to loosen money and thus risk creating bubbles.
In other words, inflation targeting makes the boom-and-bust cycle worse following supply shocks, while NGDP targeting doesn’t.
From the standpoint of macroeconomic stability, then, NGDP targeting is superior because it allows inflation to accelerate and slow to counteract fluctuations in productivity. It moves the money supply only in response to changes in the demand for money balances, and not to supply shocks that mimic the effect of these changes on prices but call for a different monetary response.
Participants in the Fed meeting at the start of November raised three concerns about NGDP targeting. They were concerned that it “would involve substantial operational hurdles, including the difficulty of specifying an appropriate target level.” This concern applies equally, of course, to inflation targeting: Any target requires a choice of the level to target.
They also wondered whether policy makers “would continue adhering” to an NGDP targeting strategy “even in the face of a significant increase in inflation,” and whether the plan would have any credibility if the public doubted the policy makers’ commitment. Again, the same doubts apply to inflation targeting. To maintain their credibility on price stability, central banks have had to tolerate painful, though short-term, increases in unemployment.
NGDP targeting can be seen as a form of flexible inflation targeting. If the economy averages 2.5 percent real growth per year, a 4.5 percent NGDP target will yield an average inflation rate of 2 percent. In any given year, inflation will be higher than that rate, or lower, depending on whether real growth is weaker or stronger than usual. This flexibility ought to make NGDP targeting easier to sustain because, unlike strict inflation targeting, it doesn’t exacerbate the business cycle when there are supply shocks.
The principal reason the central bankers gave was that “switching to a new policy framework could heighten uncertainty about future monetary policy.” As Scott Sumner, an economics professor at Bentley University, points out, that fear would be reasonable if anyone knew what the current “policy framework” was. The Fed doesn’t follow a strict inflation target as it stands. If there is some other rule it follows, it hasn’t shared it with the rest of us. Its conduct of monetary policy over the past few years has been ad hoc. An NGDP target, unlike an inflation target, would also have the virtue of adhering to the Fed’s legal mandate of seeking to minimize both unemployment and inflation.
A major obstacle for NGDP targeters is that our idea is novel even to most well-informed followers of economic-policy debates. But we do have some experience with it. Josh Hendrickson, an assistant professor of economics at the University of Mississippi, has shown that from 1984 to 2007 the Fed acted, for the most part, as though it were trying to keep NGDP growing at a stable rate. Whether by design or accident, it did so -- and the result has come to be called “the great moderation” because of the gentleness of business cycles in that period. We should target NGDP again, and this time reap the benefits of predictability by saying so.
(Ramesh Ponnuru is a Bloomberg View columnist and a senior editor at National Review. The opinions expressed are his own.)
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