## Thursday, March 29, 2012

### Koenig on Nominal Income Targeting

Koenig has a short paper that discusses nominal income targeting, comparing and contrasting it to the Taylor rule.

He argues that nominal income targeting is an example of flexible inflation targeting, as is the Taylor rule.

His version of nominal income targeting is a level target. However, it is not the same as the usual proposal of having a series of targeted levels increasing at a constant growth rate--such as 3% or 5%.

Instead, the Koenig version of nominal income targeting sets a target for nominal GDP 5 years in the future by taking the current price level, increasing it based upon a targeted inflation rate, to get a target for the expected price level and multiplies that by the current forecast for potential output five years in the future. The math is in logs, so it is the price level plus 5 times the target inflation rate plus the expected level of potential output in five years that result in a target for nominal GDP in 5 years.

Of course, next year's target will already be determined, approximately 4 years ago. There would be an already determined set of targets for the next four years that the Fed would be seeking to hit now, with the fifth year's target being newly set.

That Koenig should see this as an example of flexible inflation targeting should be no surprise. First, there is an inflation target in the rule. The target for nominal GDP is set according to a given inflation target and a changing estimate of the level of future potential output.

More importantly, the current price level is adjusted by the targeted inflation rate to generate a quasi-target for the price level five years in the future. The expected value of potential real output is then added to the price level to find the target for nominal GDP. (The log version.)

Suppose for one reason or another, the current price level is below its expected value this year. This might be because nominal GDP is below target or else because potential output is higher than was forecast. It is this unusually low price level that is projected five years into the future, generating a "low" quasi-target for the price level in five years. When added to the estimate of potential output in five years, this results in the target for nominal GDP.

With inflation targeting, assuming a 2% rate, the goal is for prices to rise 2% from their current value, wherever that happens to be. Koenig's version of nominal income targeting would seek to make the expected price level, five years from now, approximately 10% higher than the current price level, whatever it happened to be. The nominal income targeting element would occur because if potential output were different from what was expected, then the price level would vary from this expected value.

What is the benefit of adding this element of inflation targeting? I don't see one. Worse, this scheme could generate a large sudden change in nominal GDP five years in the future--between the target for 4 years and 5 years. The year four target is already determined. If the price level is extra low or high this year, then the five year target will decrease or increase in proportion. This would not be due to a sudden shift in potential output between year 4 and 5. The equilibrium price level would suddenly need to shift between year 4 and 5. While we would have 5 years to plan for this, it seems likely to be disruptive.

The other element, constantly forecasting potential output in the future, is very focused on a target for inflation (or the price level.) There is no need to worry about the current price level at all. Take the current target for nominal GDP and add to it the "target" for inflation times 5 and add that to the forecast growth of potential output over the period.

I support a target growth path for nominal GDP with a 3% growth rate rather than 5% or 2% because I favor a stable price level and nominal income growing with real income. I favor nominal income targeting because I think trying to stabilize the price level when there are supply shocks is very disruptive.

Still, why the trend of 3%? Obviously, this is based upon an assumption of a 3% trend growth rate for potential output. It is hard to understand why one nominal GDP growth rate would be better than another without some assumption regarding trend growth of potential output. (Frankly, I find 2% inflation to be a complete puzzle. Why 2 rather than 1, .2, or 3?)

On the other hand, it is not at all clear what benefit is generated by continual readjustment of the growth rate of nominal GDP. Koenig is certainly correct that any such adjustment should have a lead time, and perhaps 5 years is appropriate. But rather than set a level for nominal GDP five years in the future based upon expected growth of potential output over the next five years, I would instead adjust the growth rate five years in the future. For example, if there is really good reason to believe that potential output will be growing 1% per year five years in the future, and will remain at that low rate for many more years, then perhaps committing now to that new growth rate would be desirable. So, for the next five years, the targets for nominal GDP would continue to grow 3%, but then, starting in five years, the targets would rise only 1%.

The way I see it, the 3 percent target would be generating mild inflation because real GDP growth has slowed down. To fix what appears to be a permanent "problem," of a new, slower growth rate, an adjustment is made now, taking effect after people have time to adjust to it.

However, I don't think adjusting the target every single year, even with five year warning, is desirable. Partly this is because I am doubtful that much trouble is caused by having a productivity slowdown result in mild inflation. Or, on the other hand, there being a mild deflation due to an acceleration of productivity growth. When do short run "supply shocks" become new trend growth rates of potential output? When does the superior ability of final goods prices to adjust turn into a problem?

Further, making the adjustments in the way proposed by Koenig appears problematic. Again, the target for nominal GDP is already determined for year four. Suppose that this year it is determined that there will be a productivity slowdown over the next five years. The target for nominal GDP in year 5 is then set so that the expected price level will be such that the inflation rate will be at target. This involves a decrease in the target for nominal GDP in year 5. The change between year 4 and year 5 could be quite sharp. Since the slowdown in potential output isn't going to be happening between year 4 and 5, this implies a large drop in the equilibrium price level. Again, there will be plenty of time to get ready for that nominal shock, but it still seems like it would be disruptive.

It is good news that skilled economists at the Federal Reserve are taking a serious look at nominal GDP targeting. In terms of internal Fed politics, I am sure that showing continuity with flexible inflation targeting is helpful. Still, smuggling in too much inflation targeting can cause problems.

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