Monday, October 24, 2011

WSJ on Nominal GDP Targeting

Kelly Evans, of the Wall Street Journal, wrote a column critical of nominal GDP targeting.

There are at least three problems with this strategy, however. First, it assumes that the Fed can sensibly determine the "right" trend for nominal GDP. Second, it isn't clear that it can actually achieve any such target. And third, doing so would run a huge risk of conflicting with the Fed's congressional mandate to promote "stable prices"—something that can't unilaterally be rewritten. This is because any boost to nominal GDP may well come more from higher inflation rather than from faster growth in underlying GDP, which Goldman acknowledges. After all, the economy's real potential growth rate has been slowing for decades.

What should we make of these three points?

1. Can the Fed find the "right" trend for nominal GDP?

In my view, the right trend growth rate for nominal GDP is the trend growth rate of the productive capacity of the economy. This generates zero inflation over time. If the trend shifts, then the result will be inflation or deflation, but unless the shift is extreme, it will be modest.

More challenging is determining the correct level at which to start the trend. The obvious choice would be the current value of nominal GDP. However, the U.S. spent 24 years on one growth path, and suddenly shifted to a new one that is 14% lower. If the growth path of prices and wages had also shifted to lower growth paths--14%, or even to something consistent with plausible estimates in changes to potential real GDP, say 7%, then going forward from where we are now would be sensible.

I am still confident that if the U.S. continues on the current low growth path of nominal GDP, eventually real output will recover to potential. It might even help if the Fed came out and explained that they want the growth path of nominal GDP to be permanently lower and that prices and wages need about 7% deflation to adjust to it. In other words, maybe the Fed should stop promising 2 percent inflation if we really need a year of 7% deflation and then 2% inflation going forward.

However, I think that it is much better to shift to a higher growth path. The notion that this is some kind of out of control inflation is absurd as long as the new growth path remains below the growth path of the Great Moderation. As far as I know, no one, and certainly no market monetarist, has advocated that nominal GDP rise above the growth path of the Great Moderation. The limit of these proposals is a return to the 5.3% growth path that existed from 1984 to 2007, and most of us have been advocating something less--at least modestly lower growth rates (say 5%,) and some kind of upward shift to reverse part of the drop.

For example, I recently suggested matching the growth rates in nominal GDP for the Reagan/Volker recovery of 1983 and 1984. After a 19% increase in nominal GDP over two years, then return to a 5 percent or 3 percent growth rate.

An alternative methodology is to return to 2007, and start with a new growth rate from that point. Apparently, the Goldman-Sachs proposal selects 4.5%, which would be the supposed inflation target of 2% plus an estimate of productivity growth of 2.5%. I have used the same approach with a 3% growth rate for nominal GDP starting in 2007. Oddly enough, nominal GDP is currently about 7% below that path, and closing that would be consistent with closing the output gap while leaving the price level stable.

This ambiguity about the proper growth path should not be exaggerated as an weakness. The key idea is that once on a target growth path is selected--stay there. When errors occur, reverse them and return to the path. And let everyone know that is the plan.

Evans doesn't discuss any of these issues. Her arguments are:

First, it is tempting, but probably mistaken, to assume the Great Recession came along and knocked the U.S. off an otherwise sustainable growth track. It wasn't an external shock, but internal weakness, that led to the economy's collapse.

One worrying aspect of GDP growth prior to 2007 was that it came even as real household incomes stagnated. Assuming that boom-era growth rates were sustainable, and not fueled by a surge in house prices and a credit boom that simply pulled forward demand from the future, is a huge leap in logic.

This is a very serious error. The problem, according to Evans, is that households couldn't afford to keep nominal expenditure growing on a 5 percent growth path. Apparently, only the appreciation of the houses and borrowing provided the funds needed to keep nominal GDP growing.


The basic identity of macroeconomics is that income is equal to output. This is true both in real terms and nominal terms. There is always enough nominal income to afford the nominal value of output. There is never any need to borrow in order to afford to buy nominal output. Home or other asset appreciation isn't needed for people to afford a level of nominal expenditure equal to nominal output.

If real household income did stagnate, with a regime of nominal income targeting, nominal household income (when added to business income) would grow exactly the needed amount to provide the means to purchase the growing nominal output. Sadly, unless this is about growing retained earnings, the result would be higher inflation.

There is an issue, but Evans is mistaken about its nature. C-

2. Can the Fed can actually achieve its target.

This is certainly a concern. With the Federal Reserve's target interest rate at .25 percent, skepticism that reducing it to zero--supposedly the lower nominal bound for interest rates--would raise demand, seems plausible. Market monetarists advocate cutting the interest rate the Fed pays on reserve balances to something slightly less than zero and then purchasing as many assets as necessary to reach the target. To the degree it isn't expected to work, then interest rates on these other assets the Fed purchases would fall.

But how does Evan's explain the problem?

Consider how recent gains in the consumer-price index, particularly in food and energy, have outstripped any increase in wages. This has hurt real income growth, undermined consumer confidence, and weakened, not strengthened, the economy.

For the Fed to generate inflation, it needs households to believe the central bank is fueling not just higher prices but wage gains, too, so that they start spending more. Otherwise, households will simply tighten the purse strings instead.

She is back to this problem about people being too poor to afford the level of expenditures consistent with the target for nominal GDP.

Should I play the Zimbabwe card.? The people in Zimbabwe were and are very poor, but their nominal GDP in Zimbabwe dollars far surpassed the growth path of nominal GDP being proposed--probably for the next century or so.

Of course, Zimbabwe is hardly a model economy. But it illustrates the error. A failure to distinguish between real and nominal values.

An increase in consumer prices, ceteris paribus, is an increase in nominal GDP. If an expansionary monetary policy raises consumer prices, then nominal GDP increases. This does not create a difficulty for targeting nominal GDP. It would be a way, (not particularly desirable,) by which nominal GDP would increase.

The notion that households expecting higher prices in the future will reduce nominal purchases now, so they can wait and pay the higher prices in the future, is implausible.

Further, while wages form a significant portion of income, there are the other forms of income too--rents, interest, and profit. If prices rise and wages, interest and rents don't rise, then profits rise.

Finally, there is a confusion between real wage rates and total wages. If demand rises, and prices rise and wages don't rise, then it becomes profitable to expand production and hire more workers. While the real wages of those who were already employed may fall, the real wages of those who were unemployed rise.

Unless the increase in nominal GDP is matched by an exactly proportional increase in prices, then there will be at least some increase in real incomes. Regardless, the ability to spend depends on nominal income, not real income.

Moreover, the level of general inflation it would take to transform housing, the thorniest problem facing the economy, would be huge. Boosting home prices by the 15% to 25% that Barclays Capital reckons many households are underwater "would in all likelihood be prohibitively expensive in economic and social terms," says the firm.

The goal of nominal GDP targeting isn't to "transform housing." An increase in nominal GDP to its target growth path would presumably raise housing demand to some degree. This would raise housing prices. Some of those who are "underwater" on their homes would have higher incomes--perhaps some family members would be employed. Perhaps some of them own businesses that would earn more profit. This would make them better able to make their payments. However, there is nothing in nominal GDP targeting that requires that no one be "underwater" on a home mortgage or that total nominal consumption, much less the consumption of each and every person, rise to the growth path of the Great Moderation.

I suppose Evans can be excused for confusing nominal GDP targeting with proposals to raise inflation. Krugman, for example, has said that the "economics" of GDP targeting is increasing expected inflation to reduce the real interest rate and so generate more real expenditure. Rogoff has been calling for inflation to help the housing sector. Krugman treats nominal GDP targeting like a public relations ploy to promote inflation.

No. Nominal GDP targeting is a monetary regime. If nominal GDP falls below target, then it is the responsibility of the monetary authority to get it back to target. If this results in inflation, then the inflation must be suffered. The purpose of the policy is not to generate inflation.

What about Evans' second concern? Again, some justified confusion with proposals to raise inflation. But some very bad economics. D-

And that leads to the third concern.

3. Is nominal GDP targeting consistent with the Fed's mandate for price stability?

The Fed actually has a dual mandate:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Well, that is more than two things, but maximum employment and stable prices are generally considered the two important bits.

Nominal GDP targeting changes the monetary aggregates in such a way as to accommodate changes in the demand to hold those aggregates, (offsetting shifts in velocity,) so that nominal expenditure on output grows with the long run potential to increase production. That looks good.

When there are short run shifts in that "potential" output, nominal GDP targeting does nothing to reverse the consequent short run changes in prices, allowing the price level and inflation to fluctuate in the short run. Given all of the focus on the "long run" above, that looks consistent.

And what is the alternative? Have the Fed institute a contractionary or expansionary monetary policy to reverse those changes in the price level. Since a contractionary policy aimed at reversing a supply-side shock to the price level is likely to force employment lower, that looks inconsistent with one aspect of the Fed's mandate.

The CBO estimate of the productive capacity of the economy has increased in each and every year. The growth rate has been less than the 3 percent trend of the Great Moderation for the last 5 years, and so, nominal GDP targeting at the 5.4% trend of the Great Moderation would have resulted in slightly higher inflation than the 2.4% trend--close to 3% for many quarters and near 4% for a few quarters.

If the slowdown in productivity is permanent, then perhaps a shifting the growth path to a slower growth rate would be sensible. However, such an adjustment should be deliberate and with plenty of warning. A shift to a 14 % lower growth path, mostly over a period of one year, is not the best way to proceed.

So, what of this final criticism? Complete failure to look at the Federal Reserve's actual mandate. And, more importantly, a focus on the short run consequences of the regime rather than its long run effect--which is the criterion of the Fed's mandate. F.


  1. Bill,
    I thought this was a great post.

    The output gap you're talking about is basically the same thing as what they use in this paper:
    (if you go to it from Williams' page, they also have an excel with the data).
    The Kalman filter approach avoids the problem of where to start the trend. You would still need to forecast out this potential GDP (and it turns out it is correlated with GDP growth).

    I don't trust the CBO measures very much.

    There is one part I am not clear about that I have been thinking for some time. Mainly the point about the real output gap defined relative to zero inflation. If people in the economy expect 2% inflation, then there are no distortionary effects. The distortion comes from unexpected inflation.

    So basically you would have to estimate a potential real GDP and then add an adjustment for whatever the central bank's inflation target is.

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