The problem with NGDP level targeting

As it was the case during recent recessions, the government is called once again to the rescue. This time around governments and central banks have thrown everything but kitchen sink at the “crisis” but all effort was in vain.

On idea that is being thrown around as solution is monetary regime: Nominal GDP level targeting.  The latest to propose the idea is Jan Hatzius of Goldman Sachs who says:

Not a Panacea, But Probably the Best Option:

Under our forecast of high (and gradually rising) unemployment coupled with renewed disinflation, further monetary policy easing would be appropriate. We believe that a nominal GDP level target paired with additional large-scale asset purchases would be a good framework to deliver such easing. Asset purchases enhance the credibility of the shift in the target, and the shift in the target raises the likelihood that the asset purchases will be effective. The whole is greater than the sum of the parts. The case for such a policy would strengthen further if inflation fell sharply and the risk of deflation reappeared clearly on the radar screen.

The credibility of the policy could be strengthened further via a broadening of the assets to be purchased and/or renewed fiscal expansion. But these policies would probably require the explicit cooperation of Congress, which seems unlikely for the foreseeable future. Thus, we believe that the Fed’s most promising option for delivering significant further policy easing would be a shift to a nominal GDP level target coupled with large-scale asset purchases.”

In plain language what Mr. Hatzius proposes is more monetary stimulus. I do not want to discuss the impact of the stimulus here. My problem today is with the monetary regime that he advocates: NGDP level targeting. Besides the monetarist critic that money should be neutral in the long rung, my “beef” is  also with the target itself.

Here is why. The last decade has been the Inflation Targeting decade. Central banks chose a medium term target and did their best using monetary policy tools to bring inflation rate close to the target. Some central banks had more success than others. However, central banks could have chosen to target the price level instead of the inflation rate. In fact some did, Sveriges Riskbank 1931, and the solution was even proposed for Japan in the 90s. This regime has one major problem: what to do with the bygones.

Let me explain. If you choose to target a rate of growth, i.e GDP or prices, the central bank should act symmetrically for deviation above or below the target. Assuming that the target is 3% and inflation at the end of the year is at 2%. Than the central bank can loosen the monetary policy to bring inflation to target in the future. If the inflation is above target than the central bank will tighten monetary policy.

Let’s now look at the example with level, GDP or prices, targeting. If the GDP or prices are below the level that is the target than the central bank loosens monetary policy. But if the GDP or prices are above the target level should the central bank stop growth?? Unfortunately to conserve credibility central banks will have to reverse the growth of GDP or price levels (i.e deflation) in line with the target. In other words a level target has a ‘memory’ in the sense that periods of time whereby prices/NGDP are above the target path will be compensated for by a correspondingly lower prices/NGDP  in a later period to attain the level target path once again.

This is a very important difference in the way monetary policy will be implemented. In the growth rate version the policy is forward looking and past deviations from target do not matter. In the level version the policy is backward looking and past deviations from the target need to be corrected.  That is why I said that it is all about the what to do with bygones.  Or,  in the growth rate targeting bygone will be bygones.

One other problem I see with switching to the level targeting model is the communication to the public of the target. People understand better GDP growth rates and inflation rate than the level of GDP or price levels.

Maybe in good times there is no difference between the two targets. But in bad times, like today, level targeting is a mistake and it could cost us dearly.


8 thoughts on “The problem with NGDP level targeting

  1. Alright…some questions, how effective is NGDP targeting when confronted with the zero bound rate?
    For that matter how effective is monetary policy when the economy is in a liquidity trap, as the case of the US? And how often can you use QE as a non-conventional monetary policy? QE 1 and 2, although good for the economy have been unpopular with political support groups.

    1. There are plenty of people out there, modern monetary theory, who seem to think that targeting NGDP is the only solution out the current crisis. I do not subscribe but they have some good arguments.
      They advocate higher budget deficits to bring NGDP back to a target or trend.
      I do not agree with you though that QE 1 or 2 have been good for the economy. They just offered ammunition for the second wave of the current crisis.

      1. “They just offered ammunition for the second wave of the current crisis”. How is that?
        From what I know the point of QE 1 and 2 was to lower Gov. crowding out by taking off the market long term bonds and swapping them with short term maturity bons. That implies lower incentives to buy bonds, which is kind of the same thing which would have happened if the FED would have been able to lower the interest rate. Am I missing something?

      2. Most of the time is not about what we miss is about what we do not want to see. 🙂
        The first clue should be the name: Quantitative Easing. It should convey the fact that the FED is going to provide more cheap money
        The second should have come from the speech where these measure were announced : Policy Options for Further EasingNotwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus.
        Third, if you look at M1 growth in the US you would see that the rate of growth increased from 4% in 2008 to 18% in 2009 (QE1). Then again in 2010 to 2011 from 4% to 22% (QE2).
        And fourth, credit growth has remained low, 2% a year in 2011 (2% below the 10 yr average) while public debt has grown exponentially and keep going up. The crowding out effect is well at work.
        One more thing, how did banks mange to report profits in 2008, 2009, 2010? Cheap funding which increased the margin on government bonds (i.e.. funding public debt) and trading.

        These are the things I looked at when I said that QE1 and QE2 were no different than policies fueling the bubble up to 2007. But that is just my view. The truth is out there. 🙂

      3. MMT ar not the same people as the market monetarists. The MMTers are more fiscalists than monetarists, contrary to what their (confusing) name suggests.

  2. @Florin Bejan
    Indeed, although in a recent paper Lars Christiansen kind of bundled them up together.

    But to my knowledge both favor NGDP level targeting. But I could be wrong, my post is about the target itself not about its supporters. Thanks for pointing out the difference, though.

    1. I see Cullen’s site (PragCap) in your blogroll, he promised a piece about NGDP soon and he hinted he’ll be as critical, at least about the reasons behind it, as they were about the QEs.

  3. I like Cullen a lot for his market commentaries. With MMT I have some problems. I know the literature, until recently, about the NGDP level targeting. When you work for an inflation targeting central bank there is always someone saying that price level is a better target. so, I have an idea on what to expect.

    In general I like the MMT but this is one aspect I do not endorse. Another one is thier view on money creation and all the theory that “governments spend to tax and not the other way around”.

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