The Economist on Targeting Unemployment

The Economist (G.I., not R.A.) has a post on "Should the Fed Target Unemployment."

It is about Federal Reserve Bank of Chicago President, Charles Evans' proposal for more monetary stimulus. I have already congratulated Evans' for mentioning a target for nominal GDP in his speech.

What about a target for unemployment? In my view, it is a mistake for the Fed to target any real variable, which includes both the unemployment rate or the output gap. Of course, when the Fed combines that in a function that trades off inflation, the Fed is implicitly targeting something nominal, even if they call it "social welfare."

Further, while I think of nominal GDP as the flow of money expenditures on output, and would encourage others to think of it in that way as well, it certainly can be decomposed into a real portion--real GDP, and a nominal portion--the price level as measured by the GDP deflator.

One of the criticisms of nominal GDP targeting is that the inversely proportional tradeoff between price level and real output fluctuations don't necessarily maximize social welfare. Perhaps the central bank should choose less output variance and more price level variance or vice versa.

The reason I support GDP targeting is that I believe the slow, steady growth in money expenditure provides the least bad macroeconomic environment for microeconomic coordination. Letting everything else--interest rates, the price level and inflation, the unemployment rate, and real output--adjust according to market forces is desirable. Having technocrats use "monetary stimulus" to manipulate unemployment and inflation to maximize a "social welfare" function is wrongheaded.

My concern with the Economist, on the other hand, is:

There are a lot of ideas floating around for operational frameworks that would better motivate the Fed to boost output and employment. Price-level targeting and nominal-GDP targeting are among these. The thinking is that when either falls below their long-run preferred path, the Fed would undertake more aggressive monetary easing to get them back. This would raise inflation but hopefully, also raise employment.

There are merits to these ideas but they seem to be weak substitutes for simply raising the inflation target. When nominal rates are stuck at zero, a higher inflation target makes real interest rates more deeply negative, which should boost demand and employment through the usual channels. However, raising the inflation target subtracts from the central bank credibility which could be costly to recover. Given the dire state of the world economy this may be a tradeoff worth making, but it must be dealt with, not brushed under the rug by adopting a new regime.

The purpose of shifting to a regime of targeting the growth path of nominal GDP isn't to get more inflation now so that real interest rates can be reduced now. It is true that a nominal GDP growth path doesn't target inflation. The expected price level is the target for GDP divided by potential output. The target for GDP is known, but potential output must be estimated. And so, the price level must be estimated as well.

However, because there is very little chance of the productive capacity of the economy going into a progressive collapse, the series of targets for the level of nominal GDP target cannot generate persistently high inflation, much less accelerating inflation. Even if there is an adverse productivity shock, and the growth path of prices rises now, and so there is inflation as the price level adjusts to a higher growth path, there is no reason to project that into the future, much less imagine that accelerating inflation is possible.

On the hand, the "simulate the economy to increase inflation, lower the real interest rate, expand demand and lower the unemployment rate," can generate exactly that problem. If some level of unemployment is determined to be "too high" and higher inflation is assumed to somehow fix it, and so the Fed changes what it is doing to fix it, worries about credibility naturally arise. Is this just step one towards a repeat of the seventies? Evans seeks to handle that by keeping inflation in the "reaction function," but is it credible?

With a regime targeting nominal GDP, returning nominal GDP to target is building credibility. Perhaps some episode of returning GDP back down to the target will be needed to prove the Fed is committed to the new regime. But it is important to understand that with an nominal GDP regime, if there has been an adverse productivity shock, then the inflation that results cannot be projected into the future.

Nominal GDP is far below its trend growth path from the Great Moderation, and I don't favor returning there ever, much less promptly. I favor choosing a new growth path. However, I favor shifting to one substantially higher than where the U.S. is today. It is possible that a rapid shift to a higher growth path will result in higher inflation. This may suggest a more gradual adjustment than the one year I have been proposing.

However, it seems reasonable to me that any reduction in the productivity capacity of the economy due to the decrease in nominal GDP is a type of productivity shock. If the price level is temporarily higher because of this, then that is simply a consequence of the nominal GDP targeting regime. The return to long run equilibrium will include an increase in the growth path of the price level, and as productive capacity recovers, the growth path of the price level will fall again to a level consistent with the target for nominal GDP and the long run productive capacity of the economy.

Admittedly, everyone in the market cannot be expected to understand the operation of a new regime immediately. Economists who treat "the market" as if it is a force of nature will be little help. Coming up with estimates of the future path of potential output, and the equilibrium value of the price level and publicizing it could help.

It would not be a good thing if people projected temporary price increases into a permanent inflation rate. Pricing strategies based upon that confusion will result in firms pricing themselves out of sales, firms or households accepting debts they won't be able to repay, or perhaps households refusing an attractive employment opportunity.

But regardless of any such errors, for the new regime to provide its benefits, the Fed would need to implement it. That is, if nominal GDP goes above target, the Fed should take whatever action is needed so that people expect that it will be back to the target growth path next year.