Friday, January 25, 2013

Nominal GDP and Fed Policy

The Federal Reserve continues to be wed to a type of Taylor Rule approach to monetary policy.   They target inflation and the output gap.     The target for inflation is 2%, and the output gap is 5.5% according to the CBO.   The CBO estimate of the growth rate of potential output is about 2.5%.

If the output gap closed over a year and the inflation target remains 2% and potential output grows 2.5%, that implies a 5.5% + 2.5% + 2% = 10%  increase in nominal GDP.   In other words, it would be a 10% growth rate in nominal GDP for one year, and then a 4.5% growth rate in nominal GDP in the future.

The Federal Reserve had constantly insisted that it was committed to its 2% target for inflation.   And so, the 10% increase in nominal GDP was conditional on inflation being no higher than 2% at all times.   This would require that real GDP increase 8% over the adjustment period.   The Fed hasn't been planning on this adjustment occurring rapidly, over a single year.   They have rather planned (or is it just predicted?) a gradual closing of the output gap over time.

Recently, they have suggested that inflation will be allowed to increase .5% to 2.5% during the transition period.   Since the Fed isn't targeting nominal GDP at all, this would allow for nominal GDP to rise 10.5%, though for example, a 10% increase in nominal GDP with a 7.5% increase in real GDP and a 2.5% inflation rate would also be possible.    And again, the Fed really is planning for (or predicting) a much more gradual closing of the output gap.

A Market Monetarist approach would be to instead set a target for nominal GDP that is 10% higher than the current level in one year, and then have that target growth path increases by 4.5% into the indefinite future.    A more gradual adjustment to the new growth path would be two years of 8% growth and then 4.5% thereafter.

If, instead, we are going to stay on what looks like a new growth path that is about 15% below the trend of the Great Moderation, with a new 4.5% growth rate, then the Fed should stop promising 2% inflation.   It should instead call for an immediate 5% roll-back in prices and wages.   Given the current growth path for nominal GDP, this would generate enough real expenditure to close the estimated output gap.   Convincing everyone that inflation will always be 2% is counterproductive.

If, instead, the Fed wants to close the output gap by increasing nominal GDP an extra 5.5% over some period of time (10% for a year or 8% for two years,) but it has some constraint like 2% or 2.5% inflation, then it should commit to raising nominal GDP and then keep inflation down by promoting wage freezes or wage cuts.   

And if the across the board price and wage cuts seems politically impossible or the wage cuts only combined with higher nominal GDP growth seems even worse from a political point of view, then isn't the sensible approach to follow the Market Monetarists and just drop the inflation constraint?   Commit to 10% nominal GDP growth for one year (or 8% per year for two years) and then 4.5% thereafter.   Let inflation, real output, and employment just be determined by market forces.

Of course, if prices rise "too much" during this adjustment process, and in the end, there remains an output gap, then the Market Monetarist approach is that firms must implement those price cuts to bring real expenditure to a level appropriate to closing the output gap.   If wages rise too much, then the wage cuts would be needed too!    Now, perhaps price or wage rollbacks would not occur all at once.   But with a nominal GDP targeting regime, that is what economists (including the leadership of the Fed) should be calling for if they believe there is an output gap.   Prices and wages would be "too high" relative to nominal GDP.   Promising to keep inflation on target would be counterproductive.

I think reflection on these scenarios shows why inflation targeting is a horrible mistake.

1 comment:

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