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.