Wednesday, May 16, 2012

Questions about NGDP

Before I write anything else, I want to say thanks to Scott Sumner -- his praise is honestly far more than I think I deserve, but I hope I can earn it retroactively over the next few months of blogging.

If NGDP targeting is going to continue gaining intellectual ground in economics -- and I hope it does, see here for a detailed explanation of why -- I think there are a handful of questions about it for which I don't have answers I regard as satisfactory. These are not hostile questions, and many of them relate to the particulars of implementing an NGDP target, but as does Arnold Kling of "EconLog," I think there's something worthwhile about critiquing one's own argument sincerely: it makes you think.

The first two concerns I had about NGDP targeting related to the stability of the two variables which an NGDP target would no longer target -- inflation and interest rates--and the significance of costs to any undesirable changes in those variables.

I've dealt with both of these concerns in previous posts, finding in March that an NGDP target does not risk destabilizing inflation expectations, contrary to the Fed's minutes in November 2011, in which during a discussion of NGDP targeting "a number of participants expressed concern that switching to a new policy framework could heighten uncertainty about future monetary policy [and] risk unmooring longer-term inflation expectations." Then, looking at how interest rates behaved in the United Kingdom, which had a de facto NGDP target until 2008 -- also Australia -- I found that because an NGDP target would make monetary policy could operate more through expectational channels and less through raising and lowering interest rates.

So here are my new questions.

Real output was revised downward three times during the 2008 recession, per the Bureau of Economic Analysis' statistical review process. As you can see in the graph below, the statistical revisions were no small potatoes: a total difference of $400 billion of real GDP  in the first quarter of 2009 -- a 3.1 percent gap -- between the estimate announced in June 2009 and the final number, which came out in 2011. (By the way, I got this data from ALFRED, which is a sister project to the FRED economic database. If you haven't heard of ALFRED, check it out -- it keeps the inaccurate legacy data so economists can do this sort of hindsight analysis.)My concern is that an NGDP target ends up relying on rather inaccurate measurement techniques -- such that we may think we are stabilizing aggregate demand, but what we're really stabilizing is just the BEA's proxy measurement at the time. Now, I recognize that economic data will always be imperfect. But the revisions in real GDP, and by extension nominal GDP, were far, far larger in magnitude than the average revisions in price indices such as core and headline CPI and the PCE price index. Is that not a cause for some practical concern?

Also, what this makes me worry about is how an NGDP target would respond to data revisions -- do we just seek to immediately push NGDP back up to, or down to, its path? Or in such a scenario do we practice some sort of hybrid targeting (this is an amazing 1994 paper by Hall and Mankiw on this topic)?

Here's another line of questioning. National accounts data, which includes NGDP, comes out once a quarter. The Fed is used to working with data which comes out with significantly more frequency -- months or weeks, in the cases of data on prices and labor market conditions. I understand that an NGDP target could look at these measures to gauge the path of NGDP and perhaps use a futures market as well. But it's worth remembering that a lot can happen in terms of falling of the NGDP growth rate path in one quarter.How does the Fed deal with any issues coming from the frequency of data, which may make maintaining nominal stability a slower process in practice than in theory? Do we need to get monthly NGDP estimates? Or will a futures market, plus looking at other measures (such as PCE) in between NGDP readings sufficient?

And now, one more totally distinct area. My previous examination of how an NGDP target would respond to real shocks assumes that aggregate demand is price isoelastic/"unit elastic" -- in other words, a real shock has no effect on NGDP, only the components therein. But if AD is not isoelastic, and instead it has an inelastic and elastic section (like microeconomics thinks of most demand curves in markets), then an NGDP target implies considerably more active management of demand then I had first thought, which means that investment and interest rates, given their role in the monetary policy transmission mechanism, could get pushed around a bit more than we might have thought. Moreover, if the demand curve is not entirely isoelastic, that could make maintaining the target level significantly more challenging in the context of real shocks, given any uncertainty as to the price elasticity of aggregate demand.We can see in this graph that the rate of NGDP growth was very erratic in the 1970s, which suggests that dealing with real shocks and the resultant cost-push inflation may be not as easy as isoelastic AD curve might suggest in theory.


  1. Two things:
    1) Great point about revisions. I have brought up this concern to stock before in terms of the level vs. growth target debate. Keep in mind that under Scott's proposals the central bank has control over is NGDP expectations, not NGDP itself. So the question is given revisions how do you change your target. I think Scott would argue that if NGDP is revised lower, then upon finding that out the monetary authority should adjust policy based upon the new information.
    In terms of the releases, the BEA releases an advance, preliminary, and final GDP release. However, that's not the whole story. Every July they do an annual revision and every five years they do another big revision that rebases the chained indices.
    Hence, a bigger worry is that when they do the 1 or 5-year revisions, it turns out that NGDP is actually faster or slower than was consistent with earlier monetary policy. It could mean that the earlier policy was no longer consistent with the optimal monetary policy rule. A growth rule would not suffer the same risk as a level rule in this regard. Before a central bank adopts an NGDP rule, they should perform some simulations that account for this to compare simulated performance of growth vs. level rules. It could turn out that the benefit of a level rule greatly outweighs this risk. I wouldn't know until I saw the results.

    2) Macroeconomic Advisers (sellers of a large-scale macroeconomic model by some guys who used to work at the Fed and Washington University) have a monthly estimate of nominal/real GDP. It's in their public reading room, but for some reason it wasn't coming up on their website for me to provide a link.

  2. I assume Sumner will tackle this, but I'm guessing his answer on the data issue would be twofold:

    1) We have the same problem with inflation
    2) Target the forecast

    I would add a question to NGDP supporters which I think has yet to be adequately addressed: how do we communicate the change in policy?

    The assumption seems to be that the Fed Board could announce a change and begin targeting NGDP, but I'm not sure how effective that would be. There is a very real risk that the next Fed president (Bernanke's term is up in 2014) will revert back to inflation targeting. As a result, it could be difficult for the current Fed to convince markets that they should be basing their expectations on a policy of NGDP targeting. Additionally, I think there is a real question as to whether or not the Fed is legally able to change their explicit target to NGDP. They currently have a dual (actual a three part) mandate by law. If they announce a single target, they could very well be put under immense pressure from Congress or even face lawsuits. Both problems above lead to a similar implication: Congress might need to be the body that changes the target. And getting this done through the legislative process is a beast that no one seems serious about taming.

  3. 1. Why not target expected NGDP two years forward? Revisions are by their nature unexpected, so errors in the initial estimates should not bias the results.

    2. Admittedly there is a problem if you use level targeting (which I favor) even if errors are random. Instability is created getting back on track. But in that case why not target NGDI, which measures the same thing as NGDP, and is revised substantially less?

  4. Dan, I think the NGDP target is MORE consistent with the dual mandate than the 2% inflation target. It covers both sides of the mandate. Right now the Fed is acting as if they have a single mandate for inflation. Policy would not differ at all right now if the Congress removed the employment mandate entirely. That seems to violate the intention of the law, given the high rate of unemployment.

  5. I certainly agree that NGDP targeting is more consistent with the dual mandate than what they are currently doing (in fact, I spilled 30,000 words on that argument last spring), but I think it's more likely to face political backlash. Inflation is not only the target used by most of the large central banks, but it is also the preferred target of the largest political constituency that seems to care about monetary policy - conservatives like Paul Ryan. Imagine the heated rhetoric that Ron Paul fires at the Fed coming from the mouth of one of the most powerful Republicans in Washington; it would put almost unprecendented political pressure on the Fed Board. Bernanke's reappointment or the appointment of his successor would become a huge political hot potato, and Obama hasn't shown a level of interest in or understanding of monetary policy that would lead me to believe he would take a stand to protect the Fed in that showdown. (We might have slightly better luck with Romney, assuming Mankiw has sway over that area of policy, but Krugman I think is right in accusing Mankiw of bowing to political pressure in keeping his views to himself for the most part over the last couple of years). I think the Fed would win any potential lawsuits, but I can't think of anyone that would relish the thought of trying to explain NGDP targeting to several successive hostile Congressional Committees. I have a hard time avoiding the conclusion that should Bernanke begin targeting NGDP, the policy change would more likely than not be reversed within just a couple years - whether because of politics internal to the Fed (we already have multiple Fed Presidents who appear to think that a 2% inflation target is too progessive) or political pressure from outside of it.

    I find this very disheartening. When TheMoneyIllusion began, I was convinced that it could be effective by persuading a a small number of elite economists, and eventually the profession more widely. After all, the Fed is run by a very small number of people, and, as Professor Sumner has often argued, tends to represent the consensus views of the profession. But now I think I was wrong. I think for NGDP targeting to truly take hold, either Congress will need to be persuaded strongly enough to change the Fed's mandate or Congress will need to be persuaded enough that it allows the Fed to change course if the economics profession ever manages to convincingly make a stable change to Fed policy. The goalposts are farther away that they seemed.

    The next question is: how do you change the views of a body as polarized and disfunctional as Congress? My guess is that the answer would begin with winning over smaller central banks (something Friedman often credited with the near-universal adoption of inflation targeting, and Sumner has mentioned in the past as a possible first step for NGDP targeting). But I'll leave this answer to much better political scientists than myself (which includes almost everyone).