The time is right for the world’s central banks to reconsider the framework they use in conducting monetary policy. The US Federal Reserve and the ECB are still grappling with sustained economic weakness, despite years of low interest rates. In Japan, Shinzō Abe, the new prime minister from the Liberal Democratic Party (LDP), was elected on the promise of a new, more expansionary monetary policy (Financial Times 2012). In the UK, Mark Carney, the incoming Governor of the Bank of England, is open to new thinking.
Monetary policymakers would do well to consider a shift toward targeting nominal GDP; Carney is evidently considering precisely this. They could phase in such a switch in two steps, in such a way as to preserve credibility with respect to inflation.
A number of monetary economists pointed out the robustness of nominal GDP targeting after monetarist rules broke down in the 1980s1. “Robustness” refers to the target’s ability to hold up in the long term under various shocks. The context at that time was the need in advanced countries for an explicit anchor to help bring expected inflation rates down. The status quo regime to achieve this, during the heyday of monetarism, was a money growth rule. Relative to the money growth rule, the advantage of nominal GDP targeting was robustness with respect to velocity shocks in particular.
These days, both the presumptive nominal anchor and cyclical context are very different than they were in the 1980s. The popular regime is inflation targeting. The advantage of a nominal GDP target relative to a CPI target is robustness, in particular, with respect to supply shocks and terms of trade shocks. For example, a nominal GDP target for the ECB could have avoided July 2008’s mistake: the ECB responded to a spike in world oil prices by raising interest rates to fight consumer price inflation, just as the economy was going into recession. A nominal GDP target for the US Federal Reserve might have avoided the mistake of excessively easy monetary policy during 2004-6, a period when nominal GDP growth exceeded 6%.
The return of nominal GDP targeting
Why have proposals for nominal GDP targeting been revived at this particular juncture, after two decades of obscurity? The motive, in large part, is to deliver monetary stimulus and higher growth – needed in the US, Japan, UK and the Eurozone – while still maintaining a credible nominal anchor2. For a country teetering on the fence between recovery and recession, such as the Eurozone, a target for nominal GDP that constituted a 4 or 5% increase over the coming year would in effect supply as much monetary ease as a 4% inflation target.
Some economists, such as IMF Chief Economist Olivier Blanchard (2010), have proposed responding to recent high unemployment by setting a target for expected inflation above the traditional 2% – say, 4% – as a way of reducing real interest rates in the presence of the “zero lower bound” on nominal interest rates. They like to remind Fed Chairman Ben Bernanke of similar recommendations that he made to Japan in the past.
Little support for high inflation target
Many central bankers are strongly averse to countenancing inflation rate targets of 4%, or even 3%. They do not want to abandon the hard-won 2% number that has succeeded in keeping inflation expectations well-anchored for so many years. Economists can say that the upward change in the inflation target would be made explicitly temporary, but central bankers worry that to target a higher number even temporarily would do permanent damage to the credibility of the long-term anchor.
This is also a reason why these same central bankers are wary of the current proposals for nominal GDP targeting3. Fed governors, for example, worry that to set a target for nominal GDP growth of 5% or more in the coming year would naturally be interpreted as setting an inflation target in excess of 2%, and thus again would damage the credibility of the anchor, permanently. Their reluctance to give up on 2% is unlikely to change. But it doesn’t have to.
A nominal GDP target
The practical solution for overcoming these worries entails phasing in a nominal GDP target in two steps.
One of the main communications devices currently used by the US Federal Reserve is the Summary of Economic Projections. The governors and regional presidents give their forecasts of real growth rate and inflation rates for each of the next three years and for the long run – as well as for interest rates. The press interprets these as policy statements, even if they are only labelled projections.
My proposal is to start, in Phase I, by:
- Omitting near term projections for real growth and inflation.
Do keep the longer-run projection, and keep it at the setting where it is, 2% – formerly 1.5-2% – for the US. But add a longer run projection for nominal GDP growth as well, which should be around 4-4.5% to avoid any discontinuous jumps. That number would imply a long-run real growth rate of 2-2.5%, the same as now. Nobody could call such a move inflationary. For Japan, the targets for nominal and real GDP growth would have to be set at lower levels, due in part to the absence of population growth.
A few months later, in Phase II:
- Add projections for nominal GDP growth for the next three years.
These numbers should be greater than 4% – perhaps 5% in the first year, rising to 5.5% after that – but with the long run projection unchanged at 4 or 4.5%. Much public speculation would ensue, as to how the 5.5% breaks down between real growth and inflation. The truth is that the central bank has no control over that – monetary policy determines the total but not the breakdown – and thus doesn’t know what the answer is any more than anyone else does. But the nominal GDP target would insure that either real growth will accelerate, as we hope, or if real growth falls short, there will be an automatic decline in the real interest rate which will push up demand. The targets for nominal GDP growth could be chosen so as to put the level of nominal GDP on an accelerated path back to its pre-recession trend. In the long run, when nominal GDP is back on its path of 4-4.5%, real growth will be back at its potential, say 2.5%, and inflation back at 1.5%-2%.
This way of phasing in nominal GDP targeting delivers the advantage of some stimulus now, when it is needed, while satisfying central bankers’ reluctance to abandon their cherished low inflation target.
Bean, C (1983), “Targeting Nominal Income: An Appraisal”, The Economic Journal, 93, 806-819.
Bernanke, B, (2000), “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” Chapter 7 in Ryoichi Mikitani and Adam S. Posen (eds.) Japan’s Financial Crisis and Its Parallels to U.S. Experience, pp. 149-166, Institute for International Economics.
Blanchard, O, G Dell’Ariccia and P Mauro (2010), “Rethinking Macroeconomic Policy”, IMF Staff Position Note, 12 February.
Financial Times (2012), “Monetary policy moves to forefront in Japan”, December 17.
Frankel, J (1995), "The Stabilizing Properties of a Nominal GNP Rule," Journal of Money, Credit and Banking 27, 2, May, 318-334.
Frankel, J (2012), “Inflation Targeting is Dead. Long Live Nominal GDP Targeting,” VoxEU.org, 19 June.
Feldstein, M and J Stock (1994), “The Use of a Monetary Aggregate to Target Nominal GDP” in N Gregory Mankiw (ed.) Monetary Policy, NBER, University of Chicago Press).
Hall, R E and N G Mankiw (1994), “Nominal Income Targeting”, in N Gregory Mankiw, ed., Monetary Policy, (University of Chicago Press), 71-93.
Hatzius, J (2011), “The Case for a Nominal GDP Level Target,” US Economics Analyst, issue 11/41, Goldman Sachs, October.
Krugman, P (2011), “A Volcker Moment Indeed (Slightly Wonkish),” blog, 30 October.
Krugman, P (2012a), “Two per cent is not enough”, The New York Times, 26 January.
Krugman, P (2012b), “Earth to Bernanke”, The New York Times, 24 April.
McCallum, B T and E Nelson (1998), “Nominal Income Targeting in an Open-Economy Optimizing Model,” Journal of Monetary Economics, 43(3), 553-578.
Meade, J (1978), “The Meaning of Internal Balance”, The Economic Journal, 88, 423-435.
Romer, C (2011), “Dear Ben: It’s Time for Your Volcker Moment,” The New York Times, 29 October.
Woodford, M (2012) “Methods of Policy Accommodation at the Interest-Rate Lower Bound,” presented at the Jackson Hole symposium, August, Federal Reserve Bank of Kansas City.
1 James Meade (1978), followed by Bean, Hall, McCallum, West, Feldstein, Stock, Frankel, McKibbin.
2 The new proponents show up on the left, the right, and the center of the political spectrum: Romer (2011), Krugman (2011); on the Left; Scott Sumner (at Money Illusion), Lars Christensen (at Market Monetarist), David Beckworth (at Macromarket Musings) on the Right; Goldman Sachs (2011) and Woodford (2012) in the center.
3 Central bankers have long had some other concerns as well about nominal GDP targeting. (1) One is that the public doesn’t know the difference between nominal GDP, real GDP and inflation. But communications clarity is not a reason to go with a complicated function of inflation and real growth (as in the ubiquitous Taylor rule) as opposed to the simpler nominal income target. Furthermore, the financial markets do understand the difference. (2) Central bankers also worry they may not be able to achieve the target. Needless to say, the margin around the target could and should be wide, though there is no reason why it has to be wider than the bands around the old M1 targets or the more recent inflation targets, and there are reasons to think the width of a nominal GDP band could be a bit less. Moreover, under current conditions, the shift in policy need be nothing more than a commitment to keep monetary policy easy so long as nominal GDP falls short of the target. It would thus serve a purpose similar to the Fed’s December 12, 2012, announcement that it would keep interest rates low so long as the unemployment rate remains above 6.5% - but it would not suffer the imperfections of the unemployment number (particularly its inverse relationship with the labor force participation rate and its tendency to lag other measures of expansion).