Taylor on Nominal GDP Targeting

John Taylor still opposes nominal GDP targeting. The Market Monetarist response was rapid. Scott Sumner still hopes that Taylor will get to work developing a "rule" for Nominal GDP rather than inflation. Nick Rowe's post contrasted instrument rules with target rules.

Taylor complains that advocates of nominal GDP targeting have failed to provide a simple formula for a central bank to follow--like the Taylor rule. One version of the Taylor rule is that the target interest rate should be set at 1 + 1.5*(inflation - 2) + .5(output gap.) Taylor favors dropping the output gap term, so that the nominal interest rate should be set at 1 + 1.5*(inflation - 2).

The Taylor rule implicitly makes the target 2 percent inflation. Market Monetarists favor a target for the growth path of nominal GDP. The target is a series of levels of nominal GDP that head off into the future. The goal is to keep (NGDP - NGDP*) equal to zero for each and every future date, where NGDP* is the target level at each future date. NGDP* is growing at a constant rate. The proposed growth rates vary from 5.4% to 2%. However, the key to the proposal is to choose a growth path and stick to it.

How can a central bank actually accomplish this? In my view, if a central bank finds some simple relationship between the short term interest rate in the near future, and nominal GDP in the more distant future, then that would be great. However, it must always be recognized that finding such a regularity is a matter of luck and circumstance. As soon as the regularity breaks down, then adjustments must be made. This is especially true when a short term nominal interest rate is being manipulated.

Taylor claimed that Milton Friedman would have opposed nominal GDP targeting.

For this reason, as Amity Shlaes argues in her recent Bloomberg piece, NGDP targeting is not the kind of policy that Milton Friedman would advocate. In Capitalism and Freedom, he argued that this type of targeting procedure is stated in terms of “objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions.” That is why he preferred instrument rules like keeping constant the growth rate of the money supply. It is also why I have preferred instrument rules, either for the money supply, or for the short term interest rate.

I am not sure what Milton Friedman would do, but Taylor's appeal to rules is confused. Milton Friedman is best known for proposing that the M2 measure of the quantity of money be kept growing at a 3 percent annual rate. But M2 is not directly controlled by the Federal Reserve. From Taylor's perspective, this money supply rule was no rule at all. Where was the actual rule? For example, the policy interest rate is equal to 1 + 1.5*(growth M2 - 3%)?

Of course, during the period when he advocated an M2 money supply rule, Friedman was very critical of the use of short term interest rates as an instrument. He favored looking at the monetary base, which is even more directly controlled by the Fed than interest rates. Did he develop or advocate a rule for the base? Bt = Bt-1 + 1.5*(M2t - M2t*)?

I don't think so. My understanding of "old monetarism," was that the Fed should be given discretion to adjust the monetary base however much is needed to offset any change in the M2 money multiplier so that M2 remains on target. In particular, if bank runs resulted in a decrease in the money multiplier, like in the Great Depression, Friedman insisted that it was the Fed's duty to undertake whatever quantity of open market purchases needed to raise base money enough so that the reduction in the money multiplier is fully offset and the M2 measure of the quantity of money continues on its target path. It has always been my understanding that any errors should be promptly reversed, so that if M2 falls below its trend growth path because of a decrease in the money multiplier, base money should be increased enough to return M2 to the target growth path.

Market monetarists have a view roughly similar to what is outlined above, but taking into account that the observed regularity that M2 velocity was very stable no longer holds. And so, the market monetarist approach is that the least bad replacement target is nominal GDP, and the Fed must adjust the monetary base enough to offset both changes in the money multiplier and velocity.

In my view, the task is inherently more challenging. Statistics of the money supply are reported weekly. While the relationship between depositors, banks, and their borrowers is complicated, the relationship between the demand to hold money and the quantity of money is vastly more complicated. If there is a more or less constant relationship between nominal GDP and some measure of the quantity of money, then adjusting the quantity of base money so that this broader measure of money stays on a constant growth path would be a useful approach to exercising discretion. Similarly, if there is some simple relationship between a short term interest rate and the growth path of nominal GDP, then following a "rule" based on that interest rate would be sensible.

But it must always be understood that there is no reason to expect that any constants will hold in the market system. And when these "instrumental rules" break down, it is the rules that need to change.

While watching some short term interest rate or conglomeration of bank liabilities should not be made into an end in itself, it is essential that the monetary order be based on something other than whatever the central bank likes. "Flexible inflation targeting," means letting the central bank do what it wants.

For many years, I advocated a stable price level. I now believe that this approach is flawed. When the price level is shifted due to changes on the goods side, creating monetary disequilibrium to force it back to a target is disruptive. In my view, keeping total spending on output on a slow, stable growth path is the least bad option. That is the proper rule for the monetary authority. Exactly how best to accomplish that rule where discretion is necessary.