The Fed should explicitly target GDP for the first quarter of 2012 at $16.2 trillion. Well, that is my position. This target is on a growth path that has a three percent growth rate beginning at the level of GDP consistent with the trend of the Great Moderation (from 1984 to 2007).
Some have criticized this particular growth path as arbitrary.
While I don't think it is entirely arbitrary, as can be seen by how closely the new growth path matches the actual path of GDP before the GDP collapse in the fall of 2008, I will grant that some slightly different path might be equally good or better.
If the Fed did adopt this target, then it would be committing to having GDP (spending on domestically produced final goods and services) grow 7.7 percent between the first quarter of 2011 and the first quarter of 2012. Such a growth rate is not unprecedented.
Real GDP for the first quarter of 2011 was $13.4 trillion. According to the CBO, potential GDP in the first quarter of 2012 will be $14.5 trillion. For real output to return to potential, it would need to grow 7.6 percent over the next year.
The price level as measured by the GDP deflator was 111.7 for the first quarter of 2011 . If GDP hit the proposed target of $16.2 trillion in the first quarter of 2012 and real GDP reached potential, then the GDP deflator would need to be 111.8. Such a slight increase is tantamount to a stable price level.
The target growth path of GDP, however, continues to grow from that point at a 3 percent annual rate. According to CBO estimates, the growth rate of potential output will continue to be lower than the long run trend for a substantial period of time, so the price level consistent with the target and potential output would rise. By the first quarter of 2013, it would be 113 and by the first quarter of 2014, it would be 113.5.
So, the adjusted growth path for GDP is consistent with closing the entire output gap (as estimated by the CBO) and a stable price level over the next year. However, if inflation doesn't drop to zero immediately, there is room for a somewhat less rapid disinflation.
My biggest hesitation with targeting the levels is what happens when there is a shock to real potential GDP or real potential GDP growth. If there is an earthquake that eliminated 10% of capacity, then real potential GDP would have a permanent impact. If long-term productivity growth slows, then the real potential GDP growth would slow. In either case (and their reverse), you would adopt worse policies than if you targeted the growth rate of GDP. This is because the errors compound in level targeting. This is normally sold as a good thing about level targeting since if the monetary authority lets nominal GDP fall sharply below target, then they would need to play catch up. However, if errors compound on the other side, it can be a blessing in disguise. I'm not sure which way the net benefits go on this issue, but I do not think it should be thrown to the side.
ReplyDeleteIn addition, when data is revised it can affect the whole series, which means you would have to update your path after every major GDP revision (not necessarily every revision since most do not affect data beyond the most recent quarter). If you want to make a futures market for nominal GDP, this would be an important technical hurdle. Alternately, you could set up the futures contracts as GDP growth of x% per quarter and target the compound growth so that it reaches your ideal level target.
I am not sure how productivity shocks are "compounding."
ReplyDeleteA temporary shock to the growth path (like a 10% drop in output because of an earthquake) causes a 10% rise in the price level.
If one assumes that nominal GDP would automatically fall because of the drop in real output with the earthquake, then I suppose one can blame the "rule" for causing this rapid inflation.
Anyway, the price level would stablize at the higher level.
An earthquake would mostly be a temporary shock--output would rise with reconstruction. As real output recovers, the price level falls.
To the degree that all of this effort on reconstruction rather than say, building new and better capital goods, means that output never recovers to its previous growth path, the price level would be persistently higher.
If the growth rate of potential output grows more slowly or for an extended period of time, then a given growth path of GDP would result in a higher inflation rate. (Or more rapidly, which would result in persistent deflation.)
For example, if the CBO estimates are right, then keeping GDP growing 3% would have resulted in inflation as high as 1% for a time, and something like 1/2% for the next decade.
I think a contitutional rule should have a provision for making adjustments in the growth rate. But nothing prompt and with a long lead. That productivity slow downs lead to mild inflation and rapid real growth leads to mild delfation is not really a problem.
Emergency rebasing is also a possibility. However, one relatively easy way to make that automatic is to go with GDP per capita.
If output falls 10% and the population is the same, having prices rise 10% for a time is a good signal of the real problem.
I will grant, however, that if the population falls in half, having all money incomes (like money wages) and prices double, is pretty much pointless.
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