Thursday, October 20, 2011

Williamson on NGDP targeting

Stephen Williamson has noticed nominal GDP targeting, but clearly hasn't paid much attention. Apparently, he did read the McCallum paper some years ago.

He tries to make sense of the proposal by discussing it in the context of the Taylor rule.

He writes:
Presumably the advocates of NGDP targeting think that standard central banking practice works, i.e. that a sensible approach to policy over the very short term is to specify an intermediate target for the fed funds rate, with the target set according to the current state of the economy relative to the NGDP target.
Well, no. While it is true that some market monetarists have advocated NGDP targeting for some time, we have become much more vocal about it because we don't believe that standard central banking practice "works." In particular generating expectations about future policy rates and their relationship to output gaps and inflation looks to have failed. Nominal GDP targeting isn't about creating expectations about future short term rates and how those will impact output gaps and future inflation. It is about creating expectations about the future level of nominal GDP.

He then writes an alternative version of the Taylor rule:

Thus, we could specify the implementation of the NGDP target as a rule

R(t) = p(t) - p(t-1) + c[y(t) + p(t) - y* - p*] + r*,

where y*p* is the log of the nominal GDP target and c > 0. We can then rewrite this rule as

R(t) = p(t) - p(t-1) + c[y(t) - y*] + c[p(t) - p(t-1) - p* + p(t-1)] + r*

What's the difference between this and the basic Taylor rule? Not much.

Here Williamson makes another error. What he has described is a proposal to stabilize the growth rate of nominal GDP. The proposal is to target the growth path of nominal GDP.

(i) The coefficients on the terms governing the response of the fed funds rate to the "output gap" and the deviation of the inflation rate from its target are constrained to be the same.

This is correct. While the proposal is really about a policy reaction function for short term interest rates, targeting the expected level of nominal GDP means that the expected future price level is inversely proportional to the expected future level of real output. At first pass, the expected future price level would be the target for nominal GDP divided by the expected level of potential output.

(ii) The interpretation of y* may be different.
y* may be different. In the NK literature y* is the efficient level of aggregate output ground out in the underlying real business cycle model. The NGDP targeters seem to think of y* as the trend level of output. For practical purposes it does not make much difference, as the people who measure output gaps tend to think of trend GDP as potential GDP.

"NGDP targeters" do not assume that y* is the trend level of output, and are quite aware of the possibility of "productivity shocks." And so, the potential output we have in mind would be something like the efficient level of aggregate output ground out in the underlying real business cycle model. Nominal GDP targeting doesn't require that output gaps be measured. Nor does it require choosing a measure of inflation. (By the way, the CBO estimate of potential output has been running below trend for more than five years. Williamson should get around a bit more.)

Williamson then comes to his conclusion:
Could the Fed actually achieve such a target, even if it wanted to? No. Under current circumstances, there are no actions the Fed can take that could necessarily achieve such an outcome. Indeed, it is possible that the Fed could promise to keep the policy rate at 0.25% for five years in the future, and NGDP growth could fall below the target.

Market monetarists don't generally favor keeping the Fed's policy rate at .25% for five years into the future. We don't favor targeting interest rates at all. I suspect that in Williamson's model economies, the Fed really would have to purchase all assets, and if representative agents have the wrong preferences and technology, the price level would stay the same. But the problem is with his model.
There is no magic in a NGDP target. I know people look at the state of the economy, and think that the Fed should keep trying things. Maybe something will work? Well, I'm afraid not. Even the FOMC dissenters, and their supporters are not quite ready to say that there is nothing the Fed can do under the current circumstances that could increase employment. But they should.
Nominal GDP targeting isn't about increasing employment. While I believe that it would increase employment under the current situation, the reason to use it is that it is a superior regime to inflation or price level targeting.

Anyway, Williamson's "current conditions" includes odd things like taking the interest rate the Fed pays on reserves as constant or making currency endogenous. Market monetarists strongly favor changing the first and would have no problem changing the second if it would help.