John Maynard Keynes once famously responded to the charge that he had changed his views on monetary policy by saying "When the facts change, I change my mind. What do you do, sir?" Today's central bankers respond to changing "facts" by changing their target variables.
Incoming Bank of England governor Mark Carney is the most important among big-name economists who have been lining up to show their support for yet another target-based approach to monetary policymaking: nominal gross domestic product, or NGDP, level targeting. The basic idea is that a central bank should aim to fix GDP growth, unadjusted for inflation, at around 4.5% as a means of stabilising aggregate demand and avoiding recessions. Since the financial crisis of 2008 its myriad new supporters have come overwhelmingly from the left of the political spectrum - most notably former Obama administration economist Christina Romer.
Nominal output follows in a long line of monetary policy targets that have been proffered over the past 40 years as "the right one"; for the long and the short run, in good times and bad. After the collapse of the Bretton Woods fixed exchange rate system in the 1970s, targeting of the money supply became the monetary Holy Grail. In the 1990s, as money supply targeting became operationally too problematic, the world shifted to the targeting of consumer price inflation.
But after 2008, when July US CPI hit 5.6% in the midst of a financial crisis, support for inflation targeting - which had become as close to global monetary orthodoxy as the gold standard had been in the late 19th century - melted away. Credible justification was needed for loosening policy at a time of elevated inflation. A year later, with CPI at -2.1%, such justification was no longer necessary. But those fearing a too-early tightening in policy turned to other targets.
Nominal output targeting is truly the new intellectual rage, but it will be short-lived. The reason is that its converts are all bad-weather fans. That is, they like it now, when nominal output is well below its 2007 "trend" line, meaning that the policy implies extended and more aggressive monetary loosening. But what happens when nominal output goes above its target, as it eventually will? Nominal output targeting then requires tightening, even if inflation is low - it may even require a deliberately deflationary policy stance, perhaps in the face of elevated unemployment.
We have identified 11 years between 1983 and 2003 when nominal growth exceeded 4.5% and the Fed was loosening, rather than tightening, policy (see chart above). Throughout this period, the level of nominal GDP was far above what it would have been had NGDP consistently risen at 4.5% year. Yet the Fed loosened policy in 14 out of the 21 years. These periods of rapid nominal GDP growth and Fed loosening coincided with years in which unemployment was significantly above the midpoint of the Fed Open Market Committee's estimates of longer-run unemployment.
Tightening policy when unemployment is high or rising rapidly has proven very rare, as well as unpopular. This suggests strongly that nominal output targeting has no legs: when it tells the Fed to tighten, its prominent new supporters will abandon it even more quickly than they embraced it. Indeed, two noted monetary economists have even called pre-emptively for the abandonment of nominal output targeting once it's done its job of justifying looser policy today.
"Once the nominal GDP growth shortfall has been eliminated," Michael Woodford and former FOMC member Frederic Mishkin wrote in The Wall Street Journal on January 6, "it will be appropriate to again conduct policy much as was done before the crisis".
Carney too has suggested that nominal output targeting could be useful as "a temporary unconventional monetary policy tool". Yet since the rationale behind both inflation targeting and nominal output targeting is that they anchor public expectations for the long-term, adopting them opportunistically seems a particularly bad idea.
Benn Steil is director of international economics at the Council on Foreign Relations and author of The Battle of Bretton Woods. Dinah Walker is an analyst at the Council.
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