Showing posts with label NGDP targeting. Show all posts
Showing posts with label NGDP targeting. Show all posts

Friday, March 7, 2014

Exit Easing, Enter NGDP

Let's say you're a policymaker. You worry about a variety of risks. Risks on the upside of your forecast -- like "what if wage growth gets to 3.5 percent?" -- and risks on the downside of your forecast -- like "what if GDP growth slows back down to the 2-percent range, and inflation stays near 1 percent?"

And you have yet more tough problems at the moment. Long-term unemployment is terrible, but it's not clear how much it affects wage determination. (More on that on Monday, by the way.) The risks of overshooting and undershooting full employment are asymmetric -- undershooting is far worse than overshooting -- and what constitutes "full employment" is especially unclear. If you do allow some overshoot, or you realize after the fact you've allowed it, how do you contain expectations of inflation and the monetary-policy response?

These problems, these questions, and this moment all seem particularly suited to nominal GDP level targeting. Why?

1. Because it allows for an overshoot without disordering expectations beyond it. 

This is where the "level" part comes in handy. By setting an unambiguous exit path, you circumvent the fear that a temporary overheating in 2015 would be something the Fed has to spend the next few years undoing with tighter policy in 2016, 2017, and 2018.

To the extent to which you can maintain outcomes near an NGDP path, in fact, the degree of temporary overshoot becomes a policy choice. It's determined by the starting level for the NGDP target. My view -- and, for that matter, the apparent view of the Fed's top monetary economist, William English -- is that NGDP level targeting would vastly outperform any alternative policy in terms of closing the output gap quickly without excess inflation, but that trying to return back to the pre-recession NGDP growth path probably implies too much overshoot in the medium run. Check out page 68 of the paper, which graphs a hawkish and a dovish starting point.

2. Because it neutralizes the supply-side issue.

I really don't know how close the U.S. is to its supply constraints. The level of confidence anyone can have has got to be low, though I would assign a higher probably to the "close" view today than I would have before this post. So what you really want is a policy that is robust to that uncertainty -- i.e. that would perform well whether or not supply was an issue.

This is not a particularly good trait of the current policy regime, under which the policy response to changes in inflation after unemployment drops below 6.5 percent has yet to be defined. It is one of NGDP targeting, which abstracts away from the issue of supply by allowing the Fed to just think about the path of nominal demand. The tradition of thinking about NGDP as unaffected by supply goes all the way back to Robert Lucas in 1973.

3. Because NGDP is better than unemployment. 

The last few years have shown the unemployment rate to be, at best, a questionable barometer of labor-market conditions and real economic growth. It's not likely those problems -- the shrunken labor force, long-term unemployment, demographic change -- resolve themselves anytime soon. And, if you're not watching unemployment, then what real variable are you watching? It seems to me that one runs out of comprehensive economic summary statistics rather quickly.

Saturday, July 6, 2013

Good News, Bad News, and Money

Note: Justin Wolfers writes in, telling me that the optimal k - m is probably slightly positive under uncertainty, as explained by Brainard (1967). That is, the central bank should not close deviations from forecasts completely. Read on for context. 

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If you've spent even 30 seconds listening to financial news within the past few years, you're familiar with a line of commentary that seems shallow but might actually teach us a lot about monetary policy.

It's usually phrased like this: Good economic news is actually bad economic news. That's because if payroll employment growth is strong one month, say, that should hurt (not help) equity prices because it implies, on the margin, tighter future monetary policy. Bad economic news, in this view, is in fact good news. Monetary policy will ease to compensate for weak economic indicators.

Or, in the opposite view, it's phrased like this: No, bad economic news is really just bad news, and good news is good. That's because monetary policymakers aren't prepared to fully offset economic data moving forward.

It would help to first note that these are both theories of which effect dominates the other: The marginal bad economic data point or the marginal response of monetary policy to the datapoint. I want to think about this a bit more seriously in this post. But since it's a blog post, not an academic paper, let's make some unusually simple assumptions and see where they take us.

First, your favorite stock market index is in fact a real-time indicator of expected nominal income over an arbitrary future period. (That is to say, in this model, there are no unique effects from monetary policy on financial markets but not on the rest of the economy.) We'll call this N_i in period i.

Next, let's represent the marginal datapoint as δ, which is a real number. (This is a datapoint in the abstract sense -- it's not necessarily payroll employment.) Nominal income is sensitive to the datapoint by a parameter k -- a larger k implies that, before monetary policy, nominal income is more responsible to the marginal datapoint.

Then we also have a parameter m, which stands for the monetary policy response to the datapoint. If we were being fancy, we could have a full monetary-policy reaction m(N,δ), but this will suffice for my purposes here.

A few other assumptions: Time is discrete and counted by i. Parameters k and m are positive real numbers fixed for all periods. There is one new datapoint per period. The new datapoint in period is incorporated immediately into the forecast N_i.

It follows that: N_(i+1) = N_i + (k - m)δ_i. This should be clarifying, as commentaries that argue "bad news is good news" or "good news is bad news" are saying that k - m < 0. Commentaries that argue "bad news is bad news" or "good news is good news" are saying that k - m > 0.

Now let's pivot a bit. What should k - m equal? I say zero. And, allowing N to be the policy variable of choice -- not necessarily nominal income -- you should be answering zero as well.

What does that mean, then? Bad news shouldn't be good news. But nor should it be bad news. It should be irrelevant. The marginal economic datapoint should have zero informational value for a forecast of the policy variable over an interval of time that is sufficiently long and in the future. All I am saying is give commitment a chance -- don't let a burst of good news or bad news alter long-run expectations.

This appears not to be remotely true now. The headline that prompted this post was in today's New York Times: "Jobs Data Is Strong, but Not Too Strong, Easing Fed Fears." Eek. At least in the relevant range of that δ, the argument is that k - m > 0. From experience, equity prices move sharply on the marginal datapoint all the time. And markets for the marginal datapoint appear to price it highly.

Yet I think that for U.S. monetary policy, k - m ≈ 0 if N is price inflation. My observation comes from an examination of the median forecast for quarterly annualized inflation as measured by the Consumer Price Index from 1981 to present. The forecast data comes from the Survey of Professional Forecasters via the Federal Reserve Bank of Philadelphia. The following graph is of the mean absolute deviation from a six-quarter forecast -- which for the forecasters serves as their long-run target -- one to five quarters ahead.



What I find is that the forecasters expect the Fed to erase 63 percent of a deviation in inflation (or for it to just disappear) every quarter. Suppose there's a supply shock, and quarterly annualized inflation deviates 2 percent above target. Next quarter, the deviation should be 0.74 percent, then 0.27 percent, and so on until insignificance. That's a pretty good sign that k - m is indeed in the neighborhood of zero for inflation at six quarters ahead.

Monetary policy has succeeded in making good news and bad news into no news for long-run inflation. That's a historic achievement. But if you believe, as I do, that the optimal policy variable the central bank should stabilize is the path of nominal income, then there is work unfinished.

I see this post as building on earlier notes on why interest rates are rising and why the Fed is having trouble articulating a conditional tapering strategy (see here and here for those). I have to write those posts and do that style of analysis precisely because k - m ≠ 0 for nominal income. It would be a much less nerve-wracking ride if the Fed changed its language from "if the economy heals, then we'll taper, and we'll taper commensurate with the economy" -- which leaves the desired path for the target variable totally vague -- to "here's the desired path of the macroeconomic variable we're targeting, and we'll make our way there regardless of the marginal datapoint, minimizing deviations from the path as quickly as prudent for a central bank."

But, then again, such a monetary policy approach would put most economic journalists out of work. When was the last time you saw a story on price inflation that was not a wire-service summary of new data? What is the ratio of the number of such stories to the ratio of such stories about unemployment, GDP growth, etc.? My answers to those questions are: "2008, maybe?" and "1-to-1000." How about no news at all, then?

Saturday, June 29, 2013

Carney Should Embrace NGDP

(Originally published here.)

Mark Carney's arrival as the new head of the Bank of England on July 1 is an opportunity for the U.K. to rethink monetary policy. As a Canadian, Carney is an outsider, and he'll have a clean slate because the central bank’s two current deputy governors are leaving as well. I'm hoping the U.K. seizes the moment and embraces an idea that Carney has flirted with in recent speeches -- adopt an explicit target for nominal gross domestic product.

The Bank of England works under a mandate set by the government but has operational independence in meeting it. The appointment of a new governor is a good time for a change of mandate, and that's what's required. When Mervyn King became governor in June 2003, the Treasury redefined the bank’s goal as an inflation rate of 2 percent, as measured by the Consumer Price Index. (The bank's target had previously been inflation of 2.5 percent, measured by a different inflation index.) George Osborne, the U.K.'s chancellor of the exchequer, should revise Carney's instructions more radically.

The case for replacing the inflation target with an NGDP target is by now familiar. For a fuller explanation, see this note, but here's the short version. Prices are a poor measure of the macroeconomic fluctuations that central banks exist to moderate. The best measure is aggregate demand -- another name for NGDP.

Officially, the Bank of England has been targeting inflation since 1992. In practice, it has often shown a flexibility reminiscent of NGDP targeting -- sometimes accepting higher inflation when economic growth slowed and pushing it lower when growth quickened. In 2008, though, aggregate demand collapsed, and the bank let it happen. NGDP fell some 10 percent below trend. That was a mistake. The inflation target, even flexibly interpreted, was sending the wrong message.

It's true that Carney has seemed to blow hot and cold on NGDP, but this isn't necessarily a bad thing. It shows he's open-minded on the subject -- and willing to discuss it in public, a rare trait among top central bankers. Carney’s endorsement would carry the weight of a deeply considered judgment and give Osborne a firm push.

In a speech last year, Carney called an NGDP target “more powerful” and “more favorable” than an inflation target when the central bank’s interest rate is at zero. In testimony this February, though, he raised concerns. Suppose potential real growth rises for some reason and stays higher. Then the NGDP target implies that inflation must fall by the same amount, and stay lower. “As potential real growth changes over time," he told a parliamentary committee, "either the nominal target will have to change or else it will force an arbitrary change in inflation in the opposite direction."

Identifying changes in potential growth isn't straightforward, least of all at a time like this. So Carney's probably right that now and then inflation would be forced to run above or below the desired rate until the Treasury revised its mandate and set a new NGDP target. This seems a small price to pay for the other benefits.

If Osborne and Prime Minister David Cameron can be persuaded to go along, Carney would be the right man in the right place at the right time.

Saturday, January 26, 2013

Three Notes in the Key of NGDP

We all know the line graph which shows the gap between actual nominal gross domestic product and potential, however defined as a constant-growth-rate trend, or the output of an H-P filter, a CBO-OMB assumption, or whatever.

Don't get me wrong, that's an important graph. If I could only have one graph to say "this is the problem" -- this being the recession -- I'd probably choose it over most anything else, such as the unemployment rate.

But I think we need to be giving some other parts of the argument for NGDP targeting a little more attention.

I think it's pretty well-established that expectations matter, that credible commitment matters, that uncertainty matters. In fact, I think it's clear that expectations/commitment/uncertainty -- I'm grouping these all together because they are all related and forward-looking -- all matter more than current-quarter nominal GDP. If you don't agree, I gently point you to work by Michael Woodford, Ben Bernanke, or Lars Svensson.

So if I could add any three other graphs to the canon, it'd be the following three. I'm tipping my hand somewhat for an upcoming Bloomberg post, but I recently discovered that the Survey of Professional Forecasters has been recording NGDP expectations since 1968. Better yet for those inclined -- that is, me -- they have all of the individual anonymized forecast records, mean forecasts, median forecasts, and cross-sectional dispersion statistics on the forecasts. And it's a quarterly forecast for several quarters ahead.

You can do a lot with this. I've actually never seen someone really work with Survey numbers to make the NGDP case, and this is only the tip of the iceberg. (I'm practically pleading with everyone else to write something.)

The first is a graph of mean NGDP expectations, with each line is a time series of expectations for NGDP percent growth one through five quarters out.


You can see the NGDP shock as a shock to expectations. Notice that the effects are noticeable for a full year out. It's not hard to see how a sudden collapse of short-to-medium expectations, with no "bounce-back" recovery seen in the future, could be more important than current-quarter NGDP.

The second is a graph of the dispersion of the quarterly forecasts, the immediate quarter through a year out. The dispersion is expressed as the gap as a percentage of NGDP between the estimate at the 25th percentile and the 75th percentile. (In other words, that volume encompasses the middle half of all the estimates.)


When you re-index all of the initial values to one, what you see is that NGDP uncertainty almost exactly tripled in 2009, at all forecast ranges, relative to its 2005 level.

And the third chart I posted on Twitter earlier today. It combines all of these points. Notice the downturn in expectations combined with the expansion of uncertainty -- I find this chart perhaps as convincing as the canonical graph at the top.

It shows us the forecasted quarterly NGDP growth for one through five quarters out in the first quarter of 2007 versus the first quarter of 2009. The black lines indicate the mean forecast, and the grey bands indicate the 50 percent confidence interval as drawn from the dispersion of the forecasts.

Monday, January 21, 2013

Within Reason

Scott Sumner asked if he could quote an email I sent him and a bunch of other econbloggers, which commented on a recent article in Reason magazine about nominal GDP targeting. (Some of the NGDP crowd shares a mailing list.) Here's what I had to say, and Sumner's own commentary is available here:
I am glad to see NGDPLT getting some play in the libertarian discussion, but there’s quite a bit to criticize about this piece.

(1) I do not understand the argument that macroeconomic stability would prevent sectoral rebalancing. It is a common argument, but I don’t think it withstands serious scrutiny. Macroeconomic instability ought to make sectoral rebalancing more costly.

(2) The author is wrong to suggest that an NGDP target will mean easier credit. Again, a disturbingly common argument.

(3) A “de-facto” NGDP target fails to capture one of the most important benefits — having a clear path for expectations. Many of us have written, more or less angrily, about the Bank of England because of its failure in this respect.

(4) There’s no such thing as the “correct” NGDP target. There might be a welfare maximizing trend rate of NGDP, but within a range of 3 to 6 percent, the welfare costs from missing the optimum will not be significant. I fail to see a knowledge problem. I think the author is butchering Hayek here.

(5) The paragraph recounting Anthony Evans’ argument makes no sense. So what if the extrapolated 10-year trend between 5 and 4.5 percent would capture NGDP? Deciding after the fact that you’re going to drop down onto the previous trend is the source of the problem, not anything about a small targeting error.

Thursday, August 30, 2012

Bloomberg Endorses NGDPLT

Bloomberg View's editorial board endorsed using monetary policy to target the path of nominal GDP yesterday -- making them, as far as I know, the first major media outlet in the United States to endorse the practice. Naturally, this is excellent news for supporters of NGDP level targeting like myself.
We suggest looking at an old idea that is again attracting attention among monetary economists. Recast the target that the Fed and other central banks are told to follow. Instead of a target for low inflation plus an additional primary or secondary target of high employment, focus on the money value of output -- nominal gross domestic product unadjusted for inflation. This combines prices and output in a single number.

Suppose the target was 5 percent. Over the longer term, with the economy growing at 2 percent or a little more, inflation would be 3 percent or a little less, similar to the inflation targets most central banks (including the Fed) have adopted. Here’s the advantage: In the short term, the Fed would be on target if the economy were growing at 5 percent and inflation were zero, or if the growth were zero and inflation were 5 percent.

In other words, the system would call for faster-than- normal growth when inflation is too low, and faster-than-normal inflation when the economy is in a slump. Setting a nominal GDP target wouldn’t be telling the bank to choose between so much inflation and so many jobs, so you could still grant operational independence

...

We think it’s worth a careful look, and we’re convinced of one important advantage: This approach would make the bank’s actions easier to understand and explain.
As a matter of disclosure, I write for Bloomberg View but was not involved in their endorsement.

Saturday, August 25, 2012

NGDP Is a 'Simple Rule'

The Federal Open Market Committee (FOMC) released the minutes of their meeting at the beginning of August, and most of the financial media seized on a particular passage which revealed the Fed's readiness to act. "Many members judged that additional monetary accommodation would likely be warranted fairly soon," the minutes stated, "unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery." Those words suggested a third round of quantitative easing was not far off, given the low likelihood that conditions show the sort of strengthening which has been elusive so far for this recovery.

And yet, I do not find those words the most important part of the FOMC minutes; rather, I remark upon a telling but almost entirely overlooked presentation which appears to have occurred on July 31, the first day of the meeting.

The title? "Simple Rules for Monetary Policy."

After less than a year of Fed inflation targeting at 2 percent annual growth of the Personal Consumption Expenditures chained price index, the FOMC minutes demonstrate an interest in "alternative" rules. The presentation discussed rules from a number of angles, such as their consistency with the dual mandate and their capacity to serve as "clear and transparent benchmarks." The FOMC also considered a number of problems inherent to rule-based policymaking: under what circumstances discretionary deviation from rules would be appropriate and how it would be achieved, the consequences of data mis-measurement on rule-based policy, the implications of the nominal zero lower bound on rules, the impact of "model uncertainty" on optimal monetary policy rules, and whether the policy variable(s) -- such as the short-term interest rate -- should be "inertial" or allowed to fluctuate sharply to fix the target variable at the desired level.

It is tempting to wonder whether NGDP targeting came up during the FOMC discussion, given Eric Rosengren and Charles Evans, two alternate members present at the meeting who are respectively the Federal Reserve Bank presidents of Boston and Chicago, have both endorsed it. Given explicit debate over the practice in the FOMC's November 2011 minutes, whether it entered the discussion is uncertain.

It should be obvious, though, that an NGDP level target would meet the Fed criteria voiced in the minutes. Above all, an NGDP target is a "simple rule" which fulfills the dual mandate, serves as the most clear of benchmarks, dodges the zero lower bound problem, and has been shown to outperform other rules under model uncertainty. "Hybrid" NGDP targeting, which assigns weight to both the level and rate of growth of NGDP, would most closely fit the Fed's interest in "inertial" policy rules.

The minutes do prove the consideration of Taylor-type rules, in which a nominal variable and a real variable determine the short-term interest rate. I can gather that from the Fed's concern that it may mis-measure "potential output," given that the output gap is often the real variable input in a Taylor-type rule. Another strong piece of evidence comes from the fact that "Simple Rules for Monetary Policy" is also the exact title of an academic paper written in 1999 by John Williams, who is now the Federal Reserve Bank president of San Francisco and currently sits on the FOMC.

Williams' paper focuses on minimizing the variance in three variables -- a multi-period rate of inflation, the current output gap, and the lagged federal funds rate -- in the FRB/US macroeconomic model. It also examines many of the side questions mentioned in the FOMC minutes. Williams also co-authored a second paper in 2010 under a similar name with John B. Taylor.

Neither paper considers NGDP targeting, though both discuss positively the idea of including the price level in place of inflation in the multivariable target. In practice, a rule which assigns equal weights to deviations in price level and in the level of real output is, as far as I can tell, effectively identical to an NGDP target.

Although I fully expect that the Fed's next easing move to be discretionary rather than rule-based as I would prefer it, this presentation is strong evidence that the Fed is moving -- if only in spirit and not explicitly quite yet -- towards an NGDP level target.

Saturday, July 14, 2012

How to Get the Fed to Target NGDP

Scott Sumner has long said that instead of trying to directly convince the Fed to switch to an NGDP target, what the supporters of such a target must do is convince a majority of economists of the proposition, and the Fed will soon follow.

I don't disagree with Sumner -- but I think that, looking at the history of inflation targeting, there might be a prerequisite step. What is first needed is to convince at least a handful of countries to initiate an explicit NGDP target.

New Zealand's central bank adopted its inflation target range between 0 and 2 percent in 1988. Then came Chile's central bank in 1990 with a 3 percent annual inflation target, with a range of plus or minus 1 percentage point. In 1991, Canada, Israel, and Colombia joined in. The United Kingdom signed on in 1992, as did Australia and Sweden in 1993.

With the winds of inflation targeting blowing at full gale, when did the Fed formally debate the policy and resolve that a long-term implicit inflation target of 2 percent in core CPI would be the way they went? 1994.

(See here for an excellent discussion of the FOMC's policy debates from 1993 to 2002 -- section six is on inflation targeting -- written by one of the main advocates for inflation targeting at the Fed, Marvin Goodfriend, who further discusses the later-realized possibility of an explicit inflation target here.)

Academic consensus is critical. But nothing is more convincing than success. Daniel Thornton, an economist at the St. Louis Fed, wrote in a short history of inflation targeting that:
[P]olicymakers’ belief in the efficacy of monetary policy for inflation control changed dramatically in spite of the fact that there was no fundamental refutation of what I call the monetary policy ineffectiveness proposition (MPIP). The evolution to inflation targeting occurred because central banks, most importantly the Federal Reserve, demonstrated that monetary policy could control inflation. It was not a consequence of fundamental advancements in the profession’s understanding of how monetary policy affects the economy.
The lesson learned from the inflation-targeting debates is that NGDP targeting needs to be given a test run, and that market monetarists' advocacy is best applied not at this moment towards American economists, but towards economists at foreign central banks.

The next question is to ask which central banks can be most easily swayed. Here are a few selection criteria which I find obvious: (1) the country should be small, (2) the country's central bankers should be academics, (3) the country should have a history of leading the monetary policy consensus, instead lagging like the Fed.

My conclusion is that the list of such countries for NGDP is almost identical to the inflation-targeting list. The Reserve Bank of Australia, which targets inflation of 2 to 3 percent "over the cycle," would be my first candidate, given the similarity of their target as written and in its application to an NGDP target. I've written about the Bank of Israel before as a de facto NGDP targeter; if a campaign for NGDP targeting is to begin in earnest not only in academia but in central banks, pushing Israel to pioneer the policy makes a great deal of sense. Sweden also seems like a natural pick. With that base of support, the first big-country central bank to pressure would probably be the Bank of England, given their history of sympathy with NGDP targeting.

And by that point, the Fed will be well on its way towards action.

Note: Noah Smith observes on Twitter that NGDP targeting will work differently in small, open economies. This is a good point which needs to be further developed. And it (probably) means that we need Australia or another diversified mid-size economy to give it a go.

Saturday, July 7, 2012

A Single Mandate?

Monetary policy can be a challenging topic, and no part of it more so than interest rates. Looking at the federal funds rate, which has rested at the zero lower bound since December 2008 -- so we're pushing on four years now -- it would be easy to conclude that monetary policy has been extremely loose for some time now.

The Federal Reserve's own statements confirm this, writing of the "highly accommodative" stance of monetary policy and the "exceptional" nature of the accommodation. The Fed's own monetary hawks are looking to rein in what they see as dangerous policy actions. Conservative economists, such at The Economist's Buttonwood, are calling for the normalization -- that is, hiking -- of real interest rates. In politics, Republicans are looking to give the Fed a single mandate of price stability, saying that only then will the Fed achieve phenomenal success like the European Central Bank. (Fed Governor Bullard is actually on the record in support of a single mandate.)

Yet such conclusions and actions would be in grave error.

One of the most common confusions in monetary policy is the failure to differentiate between structurally and cyclically looser or tighter policy. The former implies a structurally higher rate of inflation over the long term with essentially no trade-off in terms of employment. Few want such a thing. The latter implies more accommodation in times of trouble -- i.e., now -- and significantly more restrictive policy in times of growth.

Why then do I dislike the idea of a single price-stability mandate for the Fed? More precisely, I would consider this question as: why do I think there should be a real component to the monetary policy target, in addition to a nominal component? (See here for the Congressional Research Service's discussion of these issues; I follow a different line of reasoning, but our conclusions are both generally against a single mandate.)

When aggregate demand falls, real variables tend to respond before nominal variables -- that is, when the economy goes into recession, we tend to see rising unemployment and falling production long before we see disinflation or deflation, particularly at the level of core prices and wages. This downward nominal rigidity of prices means in practice that a single-mandate central bank routinely puts the economy into price-output disequilibrium, at which point conventional monetary policy becomes a car without four-wheel drive in the middle of a snowstorm -- it loses traction, sending both real and nominal macroeconomic variables swerving helplessly.

That's what happened to the American economy in 2008, and it's where it remains now. Even as real output collapsed and unemployment soared, the headline PCE price index -- whose inflation the Fed targets at 2 percent year-over-year -- dropped only slightly and for a brief moment as fuel prices declined. The core PCE price index has barely budged from its trend path.Nor do I buy the arguments that a dual mandate necessarily precludes the possibility of rules-based monetary policy by introducing the need for a discretionary trade-off between real and nominal variables. My answer is pretty obvious: then specify the trade-off according to a rule, as does nominal GDP, which makes it one-to-one between inflation as measured by the GDP deflator and real GDP, or the set of "H-value" rules I developed here. Such rules make the Fed transparent, predictable, credible, and accountable without a single mandate.

Central banks should target a single variable which has both real and nominal components weighted according to the relative cost of their deviation from a trend path. The only way a price-only mandate makes sense in this framework is if monetary policy has no influence over real variables in the short run, or if there are no economic opportunity costs -- instead of my estimate of them in the trillions of constant dollars -- to high unemployment, low capacity utilization, or other real-variable distortions. Neither is true.

Tuesday, June 5, 2012

The Fed's Chickenhawks

Red-tailed Hawk
During the Vietnam War, one of the strongest criticisms you could level at a war supporter came in the form of the word chickenhawk -- it meant that you were prepared to send men to war, even though you yourself had found a way not to fight. (I wasn't born then, obviously, but I read a lot of history.) Today, you could fairly call many of the conservative members of the Fed, who say that inflation is what they worry about, chickenhawks of a different sort -- monetary chickenhawks.

When inflation and nominal GDP growth ran high year after year, these supposed "hawks" failed to raise interest rates or to adjust expectations lower. In fact, in 2007 they lowered the federal funds rate when by their own reasoning they should have hiked it -- as pointed out by Scott Sumner, who got rightly indignant with them in this post of his. But when came the appropriate time for accommodation -- that is, now -- the "hawks" refuse to bring policy to bear.

In failing to curb inflation when it counts while voicing a groundless concern about inflation now, these FOMC members make themselves fair game for such charges of monetary chickenhawkishness.

And it's not as if what I and other NGDP targeters are calling for is "dovish." In fact, if you could have established a 5 percent annual NGDP growth rate target at any time from 1948 to today, it would have resulted in immediately tighter policy 73 percent of the time. Only 27 percent of the time would the establishment of an NGDP target have resulted in an immediate loosening of policy. Notice, too, that it would still have a bias towards immediate tightening after the Volcker disinflation.That to me a clear sign that NGDP targeting constitutes hawkish monetary policy. But it's not chickenhawkish policy like we have now; it's smart hawkish. The average annual nominal growth rate when our policy would have been immediately more accommodative than actual policy was 0.69 percent -- that is, as the economy was heading into or out of recession. The average annual nominal growth rate when our policy would have been immediately less accommodative than actual policy was 4.18 percent -- a veritable boom. Similarly, the average nominal federal funds rate in the former scenario was 3.46 percent; in the latter, it was 5.98 percent. (A caveat for readers: it's impossible to say if an NGDP target would be "more dovish" or "more hawkish" in general. That's because economic conditions would change as a result of the target. What I am saying is that the establishment of an NGDP target would have most often immediately tightened policy, the key words of that sentence being establishment and immediate.)

What this disparity tells us is that although an NGDP target would have been immediately more hawkish, it would also be immediately more countercyclical than the Fed's monetary policy has been.

Too often, I find, there is a connection drawn, usually by the hawks, between economists who believe in countercyclical easing and people who believe in easy monetary policy in general. That, frankly, is just awful reasoning.

Hawkishness makes as much sense as it did in 1979, when Paul Volcker took the reins of the Fed. But that hawkishness must be intelligent; it must recognize the difference between appropriately countercyclical stabilization policy and inappropriate easing. Chickenhawkishness has never made sense, and it never will.

Note: In an earlier version of this post, I mislabeled the black line in the graph; it should have said "nominal," not "real" quarterly annualized GDP growth. I've corrected the mistake.

Also, per a request from a Twitter follower:

Monday, June 4, 2012

Israel Targets NGDP

Shh...Don't look now, but Stanley Fischer, who has run the Bank of Israel since 2005, is targeting the level path of nominal GDP.What gives the Bank of Israel's NGDP level target away, to me, is the temporary increase in inflation in 2008 and 2009, which cancels out the slowdown in real growth such that NGDP growth is constant through the recession, and the tendency of monetary policy to correct for past errors to maintain a 6.5 percent year-over-year growth path; see the swing between 2006 and 2007. As real growth has slowed since the first quarter of 2011, inflation has been allowed to rise.

The idea that Israel may now be pursuing a de facto NGDP target is very exciting -- more real-world examples of the policy are needed, especially since the Bank of England has fallen off the bandwagon. Even better, Fischer has written several papers about monetary policy in which he appears more than a little sympathetic to the idea:
"It is also generally agreed that in the long run monetary policy should play a stronger role in the economy, with perhaps explicit adoption of monetary growth targets." ("The Inflationary Process in Israel," NBER, 1984)
"In the short run, monetary policy affects both output and inflation, and monetary policy is conducted in the short run--albeit with long-run targets and consequences in mind. Nominal- income-targeting provides an automatic answer to the question of how to combine real income and inflation targets, namely, they should be traded off one-for-one...Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to implya better automatic response of monetary policy to supply shocks...I judge that inflation-targeting is preferable to nominal-income-targeting, provided the target is adjusted for supply shocks." ("Central Bank Independence Revisited," AER, 1995)
If the Bank of Israel is indeed de facto targeting the path of NGDP under Fischer, the results are impressive. The Israeli unemployment rate, over 9 percent when Fischer took charge, stands just above 5 percent today, having only increased 2 percentage points -- from 6 to 8 -- during the most recent recession, and the labor market recovery post-recession was swift. Civilian employment grew right through the recession.

Private final consumption expenditures were barely dented by the recession and quickly returned to their path, as have total retail sales. Manufacturing or industrial production has also grown steadily, without the pronounced unit-root drop seen in other developed nations whose central banks target the rate of inflation. (If anything, it seems that Israel's construction sector is growing a little too fast.)

Israel is a shining example of how successful monetary policy is at macroeconomic stabilization when it targets NGDP.

Friday, June 1, 2012

The Fed's Job Well Done

The May jobs report is out from the Bureau of Labor Statistics, and it is ugly. 69,000 in May and a 50,000-job downward revision of the April numbers. Let's look at why this jobs slowdown is happening.

This is the only explanation which to me makes any sense, and it's made up of three related parts.

(1) Growth in nominal GDP has slowed.
(2) Short run nominal GDP expectations have dropped.
(3) Uncertainty as to future growth and levels of nominal GDP has increased.

Alternatively, one could phrase the causation as a fall in aggregate demand combined with a drop in AD expectations and an increase in the uncertainty attached to those expectations. Together, they add up to the recipe for a nominal slowdown, that is, one of the Fed's making. Now there very well may be other factors, such as the European distress, pushing (1), (2), and/or (3) -- but that doesn't obviate the Fed of its responsibility to counteract, to engage in stabilization policy.

The graph above, which shows the annualized monthly percent change in BLS' nonfarm payroll numbers against the annualized quarterly percent change in NGDP lagged by one quarter, makes point (1) obvious. After NGDP growth sagged in the first quarter of 2011, bottoming out at 3.1 percent, and payroll growth nearly went to zero in August 2011, the Fed intervened, suggesting some degree of commitment, and something resembling nominal stability and the sort of real growth the United States should be having after such a recession returned. Since then, it's clear the Fed has sat on its hands. NGDP growth has already slowed by roughly a percentage point since the end of 2011 -- we got new numbers yesterday in the Bureau of Economic Analysis report.

However the NGDP decline thus far understates its influence. The big change, I worry, has been in NGDP expectations, discussed in point (2). As I've documented recently on this blog, inflation expectations have dropped dramatically since earlier this winter. What I've just realized is that the inflation expectations have continued to fall. We now stand at a one-year breakeven of 0.37, a 38 percent drop just on the day. That is not a misprint. What this means is that NGDP expectations too have fallen, given that the change in inflation is demand-driven.

Onwards to point (3), which says that uncertainty is rising and compounding the problems of falling present and future NGDP. When I talk about uncertainty, what I mean is that individuals' probability distributions of where NGDP and NGDP growth will be in the short run have seen the level of dispersion increase significantly. Increased NGDP uncertainty or aggregate demand uncertainty is a strong, underlying factor pulling down NGDP growth in (1) and expectations in (2) -- as it delays commitments from firms like hiring or investment and reduces consumer confidence. The uncertainty could very well be coming from trouble in the Eurozone, but if it wanted to, the Fed would be no less able to determine NGDP expectations in such an environment. (See my posts here and here about Switzerland's central bank to understand just how powerful credible promises can be as a expectations-based channel for monetary policy.)

So that's how to read May's job report. This is what happens when you reduce NGDP growth and NGDP expectations and increase uncertainty in the context of already weak aggregate demand.

Friday, May 25, 2012

Eurocrisis = NGDP Crisis

Paul Krugman wrote a post a while back in which he looked at the data for debt-to-GDP ratios and government spending as a percentage GDP and effectively no explanatory relationship there for what's happening in the Eurozone, contrary to popular narrative. Instead, Krugman argued, Europe had a balance of payments problem.

I don't disagree with him, but I see the balance of payments problem as fundamentally driven by nominal GDP gaps, which differ strikingly between the different Eurozone nations, as monetary policy at the ECB cannot obviously stabilize on a path trend -- or keep growing even at roughly the trend rate -- nominal GDP in the 23 Eurozone nations.

The result is massive, unfathomably large nominal recessions in countries like Spain, Portugal, and Greece -- depressions, really -- amid nominal booms above trend in Germany, Belgium, and Austria. (Remember where the Eurozone is in its business cycle, and you should recognize that to be running even a small positive NGDP gap at this time amounts to a huge positive gap in normal times.)

What's going on in the Eurozone is ultimately not a debt issue, nor an issue of structural government spending. Those have undoubtedly slowed growth in the Eurozone over the long run -- but this is not a structural problem, it is a cyclical problem, a nominal problem. (See this post of mine for more on this.) Instead, these structural problems surfaced because of the nominal problem.

Note: An earlier version of this post failed to include Portugal; I redid my analyses for several of the countries to confirm that my data had not been mislabeled, but everything appears alright now. Please let me know in the comments if anything else seems faulty. Thanks. -- ES

Sunday, May 20, 2012

The Emerging 'NGDP Coalition'

NGDP targeting is rising as an intellectual force in the monetary policy debate. We know this. But what's really fascinating to me is how this rise is happening. It's not only organic -- Lars Christensen in The Economist called market monetarism "the first economic school of thought to be born in the blogosphere" -- but it's begun to unite the varying factions of economists in a way I find truly remarkable.

This is one of the signs of a world-changing idea: that everyone who has seriously considered it has lined up behind the idea, regardless of their other intellectual leanings.

The Left is coming around. Brad DeLong, one of the loudest voices of the economic blogosphere, wrote: "Target the path of nominal GDP, people!" DeLong also endorsed it at the Economic Bloggers Forum in Kansas City, which I covered here. Paul Krugman gave it the thumbs-up in a blog post here, too. Christina Romer also wrote in The New York Times calling for NGDP targeting, telling Ben Bernanke that it's time for his "Volcker moment." Matt Yglesias of Slate is also solidly behind NGDP targeting. I'm sure there are legions of others, but the point is that NGDP targeting has won (or is winning) the Left solidly.

The fascinating part is that NGDP targeting is also winning the Right. Scott Sumner, first and foremost, leads the charge -- even while he disagrees with the Left on other issues, especially income and capital gains taxation. David Glasner, Ramesh Ponnuru, Josh Barro, and yours truly. Greg Mankiw and Robert Hall also have old favorable papers in support of nominal income targeting, and even F. A. Hayek supported NGDP targeting.

So what is it about NGDP targeting that gives it this ability to transcend intellectual divides? It's not that it's merely a good idea -- there are many such good ideas which remain the province of more or less exclusively the Right or Left, or dwelled on one side for long periods of time. What makes this idea immune?

I think it's because NGDP targeting has (perhaps accidentally) stumbled upon the one common point between the macroeconomic philosophy of the Left and Right. This means that both sides like it for different reasons; in particular, Left and Right market monetarists use noticeably different language to argue the idea to their respective sides, but when we come together, we share a common vocabulary.

The Left likes it, I think, because they see it as a means to realize Keynes' desire for aggregate demand stability. NGDP falls when AD falls; it need not change from real shocks, i.e. those which change aggregate supply. What's also going on is an understanding that additional fiscal stimulus won't be happening anytime soon. Given that NGDP targeting embraces the goal of aggregate demand stability, it really isn't that much of a jump for the Left. It's merely a question of which means -- monetary or fiscal policy -- is better purposed to that end.

The Right likes it because (1) it's a monetary policy rule and (2) it solves the recession problem without fiscal policy. Rules-based monetary policy has been one of the greatest goals of the Right for the last fifty-odd years: first Milton Friedman's monetarism, focused on stable growth in monetary aggregates like M1; then inflation targeting, now in effect at the Fed; and now NGDP targeting. And rules, properly done, make sense -- expectations trump everything during the medium-run, and so unstable nominal income expectations are ruinous, and the central bank's commitment problem proves deadly for monetary policy in liquidity traps without a rule. Second, I think it's fair to say that the Right loathes activist fiscal policy -- we think it's wasteful and corrupting, worry about big government "ratchet effects," and think it creates policy uncertainty.

NGDP targeting is here to stay in the policy debate, even if it takes years before central banks officially embrace such rules. Many good ideas are owned by one side, but the reason why NGDP targeting has built (and continues to build) such a coalition is because in its message, both sides hear their own.

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.

Saturday, May 5, 2012

What Is NGDP Targeting?

A complete layman's guide to NGDP targeting

When I began blogging this January, I wrote a "mission statement" of sorts in my first post. I promised to keep you the reader "up-to-date on developments in the academic side of economics, such as emerging debates and trail-breaking research." I also pledged to dutifully avoid dryness and to introduce and explain jargon when it would serve a useful end. There's a tension running between those two objectives, perhaps inevitable but worth vigilance nonetheless -- so today I will take one of the most important new "big ideas" in economics, and take it out of the academic cloudscape, and put it within reach of the layman.

This is NGDP targeting. I've discussed it in the past on this blog -- see here -- but all of my writings approach it as an academic idea, and suppose to some extent the reader's familiarity with basic concepts. I believe in this idea and think that it should be put in practice. To that end, I feel that the best thing I can do for the cause is explain the idea and its merits to a broader audience.

The basic idea is that the Federal Reserve should use its power to stabilize the economy such that the nominal gross domestic product grows along a stable and predictable path at all times.

There's a lot in that single sentence, and this post will help you understand (1) the background concepts, (2) the concept of NGDP targeting itself, and (3) the merits of the policy.

The background concepts

If you understand what the Fed is, what its goals are, how it sets and conducts monetary policy, how monetary policy affects the economy, and what nominal GDP is, skip this section.

The Federal Reserve (informally, "the Fed") is the central banking system of the United States, and the institution charged with setting and conducting the nation's monetary policy. Along with fiscal policy, determined by the U.S. Congress, monetary policy uses the supply of money to help stabilize the economy through the business cycle (the economy's pattern of "boom and bust"). A full description of the Fed and monetary policy goes beyond the scope of this post, but note that ever since the Humphrey-Hawkins Act of 1978, the Fed has had two objectives, what economists call the "dual mandate": maintaining the maximum sustainable level of employment and keeping prices stable. In practice, this means that the Fed has conducted policy aiming for an annual inflation, or increase in prices, of 2 percent; simultaneously, the Fed seeks to prevent large increases of unemployment, which often comes from a recession, or from unemployment falling so low that inflation rises -- a scenario which happens when a booming economy "overheats."

The Fed conducts monetary policy by targeting a desired level for the federal funds rate, the interest rate at which major banks lend to each other overnight to they can meet the level of bank reserves they are required by law to hold. The Fed does this by purchasing or selling Treasury bills, the debt of the U.S. federal government, on the open market -- when the Fed sells T-bills, it contracts the supply of bank reserves, making them more scarce, and thus banks will charge more to lend them out to other banks. The Fed does this because the fed funds rate acts as a "base rate" upon which other interest rates are determined by markets; when the fed funds rate goes up, the supply of bank reserves goes down, raising interest rates on mortgages, car loans, and all of the other forms of debt which exist in the modern American economy. When interest rates rise, lending, investment, spending and economic activity generally slows; therefore the fed funds rate is the tool with which the Fed prevents inflation and unemployment from rising above their desired levels.

Nominal gross domestic product, or NGDP, is the sum of all spending in the United States economy, measured in the dollars as you and I use them. More technically, NGDP is the market value of all final goods and services purchased in formal exchange. Another way to think about NGDP is as the sum of all the goods and services produced, counted in their quantity (what economists call "real GDP"), and then multiplied by their prices (the "price index" or "deflator"). In this way, NGDP combines a "real" variable, or one which measures something actually being produced, and a "nominal" variable, one which considers prices and not actual production. GDP accounting, like the Fed, is also complex and not the focus of this post, but it is important to understand NGDP as a concept.

What is NGDP targeting, and how would it work?

NGDP targeting is having the Fed determine a path along which NGDP would grow, and using its monetary policy tools to effect that end.

In essence, the Fed would pick a rate of growth which reflects the sum of its desired rate of inflation and the historical rate of growth in real output; in the United States, this level is in the neighborhood of 5 percent per annum -- 2 percent inflation, 3 percent real growth. This would mean that the Fed would change targets from the fed funds rate to NGDP.

In some discussions, an NGDP target implies an initial level of NGDP, beyond which it grows at a constant rate. In such a scenario, the Fed would seek to hit that initial level using its monetary policy toolkit and then proceed from there.

The Fed could target NGDP using a variety of tools. It may, in fact, not need to go any further than the tools it has -- buying or selling Treasury bills in the open market, which affects the economy through the regular transmission mechanism of monetary policy, as discussed in the second paragraph of background.

Some economists have also advocated for the Fed to create a market on which traders could buy and sell "NGDP futures," securities which are priced by what the market participants expect the rate of NGDP growth to be. Similar futures markets exist in real life: for oil, for agricultural commodities such as corn and rice, etc. By purchases or sales of futures in this market, the Fed could set expectations for NGDP growth -- when the futures market anticipated low NGDP growth, the Fed would buy securities and raise expectations up to the target level.

In economics, expectations tend to be self-confirming; if people expect the economy to grow at a certain pace, then they will spend, hire, borrow, etc. in line with that expectation, and meaning that their expectations have now become reality. Therefore an NGDP futures market would help the Fed not only setting expectations for NGDP growth, but through this expectations channel, making NGDP actually grow at that rate.

The virtues of NGDP targeting

So why are academic economists actively discussing the idea of NGDP targeting? What are the main arguments of those who say that such a policy would be better than what we have now?

I see several main arguments for NGDP targeting. First, it would prevent most recessions, which are caused by a decline in aggregate demand. Second, it makes the credibility of the Fed aligned with, and not against, the policy which will counteract recession. Third, it would better handle those recessions which are caused by shocks to real variables, for example, if the supply of oil fell swiftly. Fourth, it would better handle positive real shocks -- that is, those which increase aggregate supply, which might occur if productivity were to rise faster than expected. Fifth, it would avoid the onset of impotence which comes from the "zero lower bound," when the Fed can push its target for the federal funds rate no lower than zero, and it is "out of ammunition" in terms of its conventional policy options. Sixth, the stabilization of aggregate demand would lead to higher long-run real growth in that risk-averse firms could make marginal investments which expand their production. Let us consider each of these arguments in greater depth.

First, NGDP targeting would prevent most recessions. Most recessions are "nominal" -- that is, they are not caused by a sudden change in "real" variables, like the resources we have available to us or our ability to use them productively. Recessions occur because of declines in aggregate demand, the sum of individual decisions to spend money, or rather in declines in expectations of future demand. What this means is that if the Fed maintains stable expectations for future demand, then nominal recessions will not happen. When nominal recessions do not happen, neither do all of the high costs which come from recessions -- unemployment, lower output, government debt, etc.

Second, it makes the credibility of the Fed aligned with, and not against, the policy which will counteract recession. Economists speak of the "credibility" of a central bank because if it is strong, then the central bank has greater control over market expectations. A low-credibility central bank must "prove" it wants something, because if markets do not believe that something will happen, they will not make it so by aligning their expectations with policy. For example, if a low-credibility central bank wanted to end high inflation, it would have to "prove" this by pushing down demand so sharply that the economy went into recession and inflation "reset" at the desired lower rate. A high-credibility central bank would be able to merely adjust expectations higher or lower, without the recession -- this is the story of Paul Volcker in the early 1980s -- and thus having low credibility requires costly behavior on the part of the central bank. For this reason, central banks are often unwilling to act in ways that may jeopardize their credibility, even if doing so would be "better" for the economy. In this way, the Fed's inflation target is poor policy, because every time the Fed wishes to support aggregate demand in the face of recession, it risks sending inflation above target and thus damaging its credibility. Instead, NGDP targeting would be better policy because if real growth fell, and the economy went into recession, the Fed's "default" policy -- i.e. the one it would take to preserve its credibility -- would be to increase inflation to support aggregate demand. By changing the "default" option, the Fed's incentive becomes to protect the economy from unnecessary costs, and not to protect its credibility at the economy's expense.

Third, an NGDP target would better handle recessions caused by real shocks. Real shocks, or changes in the resources available to us or our productivity, are not a product of monetary policy. They happen because of geopolitical uncertainty (oil), or bad growing seasons (corn or rice), or other reasons which, given that Chairman of the Federal Reserve Ben Bernanke is "not quite God," the Fed cannot prevent. But monetary policy can handle the event of a real shock in good and bad ways, in better-planned and more poorly-planned ways -- just as you, facing a surprise leg injury, could do things that would help you heal more quickly (say, icing, stretching, and going to physical therapy) or less quickly (say, running a marathon). NGDP targeting offers the best policy response to a real shock because a real shock reduces aggregate supply, causing prices to rise and real output to fall -- and since NGDP targeting considers, in essence, prices multiplied by real output, real shocks do not change NGDP is demand stays stable. In effect, an NGDP target can differentiate between real and nominal shocks -- and it responds to both optimally. In comparison, a real shock is a "threat" to the credibility of an inflation target, because prices "want" to rise, and so enforcing an inflation target requires reducing real output, and plunging the economy into recession, at a time when it is already suffering the supply shock.

Fourth, an NGDP target would better handle positive real shocks. Real shocks, however, do not always reduce the supply of resources or productivity -- sometimes, they increase either of these. For example, the introduction of computers to workplaces increased the rate of productivity growth substantially during the late 1990s. This was most certainly a good thing, but it presents a problem for some forms of monetary policy, because it reduces inflation. If the central bank targets inflation, it would be forced to ease policy to raise the rate of inflation, even when the economy was already booming in real terms. That is dangerous because, combining the explanation in Reason 3 and this, inflation targeting tends to magnify the booms and bust (and not stabilize) the economy in the face of real shocks. An NGDP target, on the other hand, would respond to an increase in productivity optimally: because an increase in aggregate supply causes output to rise and prices to fall, NGDP is unchanged if demand is unchanged, so the NGDP target limits the extent of the boom and prevents it from generating asset-price bubbles. What happens, both for positive and negative real shocks, is that the balance of real and nominal growth within the NGDP target shifts -- but policy is not forced to respond in ways which run against the ultimate goal of economic stability.

Fifth, an NGDP target would avoid the zero lower bound problem. When the central bank sets an interest rate, it can run into a problem during recessions, because it cannot set the "nominal" interest rate below zero, even if that is "what the economy needs" to return to stability. This is the "zero lower bound" problem, and it is most likely to happen during deep recessions -- we're at the zero lower bound today. That means that monetary policy is made useless when it is most needed. It would be like taking away the lifeboats at the moment when the Titanic hit the iceberg, as economist Scott Sumner once vividly put it. The NGDP target resolves the zero lower bound problem because if a real recession happened, the central bank would increase the rate of inflation, which means that it would have effectively cut the "real" interest rate (i.e. the interest rate minus inflation) without pushing the "nominal" interest rate to the zero lower bound.

Sixth, if firms are "risk-averse" -- meaning that they will systematically prefer low-risk, low-reward scenarios to high-risk, high-reward ones -- then an NGDP target will lead to a higher long-run rate of real growth. (This is my own argument for NGDP targeting.) Economists believe that firms in the United States are risk-averse, and that's not a bad thing in itself, but it does imply that nominal instability has real costs in the long run. In other words, if the economy is constantly swinging from boom to bust in NGDP, then if I run a business, I won't invest as much as I would have if the economy grew with more stability, because I am afraid that if I invest (say, I open a new storefront) and a recession comes, then my investment will lose value. Now expand this consideration of one firm to the entire economy: when NGDP growth is unstable, firms make fewer investments -- factories buy fewer machines, merchants open fewer stores, companies hire and train fewer employees, etc. -- and what this means is that, in the long run, the economy grows more slowly because productivity increases more slowly. Alternatively, stable NGDP growth, which would be achieved by targeting NGDP, could increase the rate of long-run real growth because of the tendency of firms toward risk aversion when they invest.

Further reading on NGDP targeting, and sources

Bennett McCallum, "NGDP Targeting."
Nick Rowe on the blog "Worthwhile Canadian Initiative."
Scott Sumner, "Re-Targeting the Fed."
     (See also: Scott Sumner's blog, "The Money Illusion," and his report, "The Case for NGDP Targeting")
The Economist, "Changing target."
     (See also: The Economist's "Free Exchange" blog.)
Christina Romer, "Dear Ben: It's Time for Your Volcker Moment."
David Beckworth's blog, "Macro and Other Market Musings"
Matt O'Brien, "A Rebellion at the Federal Reserve?"
More resources here.

Friday, May 4, 2012

Forecasting for Failure

An interesting find today when I was looking for something else in the FRED databases: the Congressional Budget Office is forecasting the slowest real recovery in the postwar era, and given trend inflation which does not rise above 2 percent, the slowest nominal recovery in the postwar era. What these forecast data tell us is that the CBO expects the trend "potential" rate of real growth -- growth in the actual production of goods and services -- to rise slowly from now until 2016 to 2.6 percent year-over-year. In the interim, trend real growth is supposed to be below 2 percent; this is the lowest on record, and a long low stretch at that.

Moreover, the CBO doesn't seem to expect the Fed to do anything much about it. In tune with the Fed's forecasts, which show inflation slowly rising to the ceiling "target" of 2 percent, the CBO expects the trend inflation rate to hover around 1.8 percent. This reflects a substantial asymmetry between overshooting and undershooting the Fed's inflation target.

What do you get when you put the two -- historically low real growth, muted inflation -- together? The slowest sustained period of NGDP growth on record. In fact, we do not return to the NGDP trend growth rate of 5 percent we seemed to have to maintain from 1992 to 2007. Although the recovery from the 2000 recession was weak, this recovery could be different -- in that, when it comes to the level of NGDP, the CBO is effectively anticipating none.This graph, expressed in logarithms of NGDP, suggests that the slow growth rates above represent a permanent adjustment downwards of the NGDP level path, with the CBO's trend estimate declining slowly to close the NGDP gap. Never mind, I suppose, that this recession is nominal, not real, and boils down to a collapse in spending in the aggregate and demand in current dollars.

Wednesday, April 11, 2012

With Interest

Does NGDP targeting require interest rate volatility?

So I've been doing some serious thinking and research over the last few days into the variant-target monetary policies I wrote about in mid-March (see here, here, and here if you're a new reader of the blog).

I'd been interested, most critically, in what economists call the "loss function" of the central bank, with variance in real output growth and inflation from their trend rates representing relevant losses. One could look at the empirical data, I reasoned, and determine how the central bank assigned relative weights to inflation and real-output deviations.

My understanding has changed a little bit as I've gone forward, namely I've recognized that interest rate variability, since it would compromise the efficiency of investment allocation and capital markets, has costs, although I think it's pretty clear that it should be substantially lower weighted than, say, inflation or real output deviations.

I'll post more about my research (and hopefully get some suggestions and feedback) tomorrow, but I'll pose to you one of the questions with which I've been wrestling: if the central bank pursues NGDP level targeting, using futures markets and expectations, would you expect that to lead to more or less interest rate volatility?

There is, of course, a rather clear argument that it will lead to more. Since it entirely ignores the policy instrument -- unlike a Taylor rule, importantly, in this respect -- an NGDP target may send instrument measures all over the place as it aims to hit a target. One might argue that we saw this happen from 1978 through the early 1980s, when the Humphrey-Hawkins Act required the Fed to hit money supply growth targets.

Then I considered the counter-argument. An NGDP target better manages expectations for nominal growth, which should stabilize interest rates and prevent the need for sudden rate cuts due to nominal shocks. That would imply that an NGDP target would outperform discretionary policies and flexible inflation targets which assign lesser weights to real output.

And indeed, I found that it is the latter thesis which is supported by the data. Above, I've graphed the short-term interest rates in the United States, the United Kingdom, Australia, and Canada. I consider Australia an NGDP targeter this entire time span.  Also, I think it's fair to say that the UK maintained a de facto NGDP target up until 2008, at which point it assigned a substantially higher weight to inflation -- I've shown this in the past. Canada is more of a flexible inflation targeter, and the US is purely discretionary, but with the strongest weight on inflation.

The order I've just listed the countries -- Australia, the UK, Canada, and last the US -- is also the order, not coincidentally, from least to most interest rate volatility. It's clear that because NGDP targeting does a better job managing aggregate demand, that the outcomes for interest rate stability are far superior to the results of flexible inflation targeting or discretionary policies.

Oh, just a small note: the Australia data series is actually the RBA's discount rate, since FRED seems to be missing large chunks of the time series, but I looked at both data sets, and the discount rate seems to be a close-enough proxy.

Friday, April 6, 2012

Not in Kansas [City] Anymore

Must-see panel of econbloggers on recovery and the long-term


Scott Sumner, Tyler Cowen, Brad deLong, Karl Smith -- four of the Internet's best bloggers on economics -- sat on a panel discussion at the Economics Bloggers Forum in Kansas City, hosted by the Kauffman Foundation. The topic was how to ensure recovery in the short run and strong growth in the long run, with questions from Brink Lindsey and the audience.

It's something you definitely should watch, if you have an hour to spare. A few thoughts and comments:

(1) Scott Sumner is clearly waging the right war -- convincing the majority of economists, rather than the Fed, that we need to target nominal GDP, not inflation -- and I got the sense he's winning. All three of the other panelists endorsed the idea, from the leftmost participant, deLong, to his counterpart, I suppose, on the Right, Cowen. A year or two ago, I don't know if this would have been possible. But given that the Fed has only recently adopted an PCE inflation target, I find myself doubting the idea that they would switch to a different target variable so quickly -- what I could see happening is an explicit statement of the Fed's monetary policy reaction function, which I now see is closely linked with my idea of an "H-value" identifying the Fed's willingness to trade off between inflation and unemployment in the short run. In effect, this would transform the inflation target into an effective NGDP or variant NGDP target. It would take much, because I read the Fed as trying to imply such a target:
In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary.  However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. [my emphasis]
(2) Tyler Cowen and Brad deLong both seemed more worried about the long term than I expected, and in ways that weren't what you'd guess. (Hint: Cowen didn't bring up his Great Stagnation.) Cowen in particular was concerned about how the financial crisis revealed structural issues in that market like an apparent change in the risk premium and a global shortage of safe assets. Both of these impinge on long-run growth because they reduce the efficiency of financial markets in allocating capital to investment.

(3) Brad deLong articulated at around three-quarters through the video a view of the 2008 recession that I think is gaining traction: It's not structural issues. It's aggregate demand, stupid. I've pointed out before that proper monetary policy allowed the market to complete major structural change in the composition of investment from 2006 until 2008, and deLong adds the absorption of real oil shocks in 2007 and turmoil in financial markets in early 2008. It was only in September 2008, when nominal spending fell off the cliff, that the stock market collapsed, financial markets froze, and that all of these structural issues came to a head. I think the "story" of structural factors undoing us is in some ways an appealing one to tell because it has an intellectual flavor, but frankly, it is simpler than that. Anyone who believes that structural factors had a delayed impact, I think, has a considerable burden in answering the following questions:
Why did it take two years for recession to arrive if the housing bust was so bad?
Why did it take a year and a half for recession to arrive if real shocks were so strong?
Why did it take several months for recession to arrive if financial market turmoil was so damaging?
How did the economy go on chugging along, despite these structural issues, for so long, only for them to matter suddenly?
Nobody is denying that structural issues can exacerbate a recession, or perhaps (the evidence is mixed on this point) slow a recovery. But I don't see a cogent argument for them being anything but contributory causes -- they are not "necessary and sufficient" for the recession.

Note: To clarify any misunderstanding in the title, I didn't actually go. (I had school.) I watched the tape. The title refers to a famous line from "The Wizard of Oz."