Central banks should target the price level not the NGDP

Yesterday the inflation data for the EU countries was released. For the euro zone inflation remains high at 2.7% while the ECB target is at “utmost 2%”. If these were normal times (i.e. before 2007) the headlines in the mainstream media would have demanded ECB to take immediate action.

Instead, we are actually witnessing a witch hunt of the Inflation Targeting (IT) regime. There are even some economists who are blaming the current economic crisis on the IT regime which was so successful that it created bubbles all over the rest of the economy (but the area which was measured by the consumer prices). In my view this is utter non-sense. The IT regime came about to solve the big inflation problem of the 70s and 80s and to introduce a transparent and independent monetary policy. It is harder (but not impossible) to cheat in a rules based policy environment.

But in our curent environment the ECB will get away with higher inflation as most economists are in fact busy trying to convince the public that monetary policy should be used to spur economic growth. In fact, all the ECB has to do these days is to forecast lower inflation and call the current above target inflation a temporary phenomenon. The trick is not new and it was used by the ECB (and other central banks) in 2011 when at the beginning of the year it was forecasting inflation for that year at 1.9% and for the end of 2012 at 1.8%. Guess what is the ECB forecasting for the end of this year and for the end of 2013? 1.9% and 1.7%. As long as the forecasts are below target the ECB does not have to act.

However, even with current inflation rate running above target there are voices saying that monetary policy in the euro area and in the US is running too tight. The measure used to show this is the Nominal GDP (NGDP) level versus a long run trend. And to solve the problem, i.e. NGDP below trend, they propose a new target for the monetary policy:NGDP level. To be honest the idea is not new or that outrageous as even Milton Friedman has mentioned something similar in his book Money Mischief: Episodes in Monetary History.

The idea in a nutshell is too relax monetary policy until NGDP gets back to its trend. I am not going to discuss the actual details of how monetary policy will be implemented in such an environment, for example you would need a pretty reliable forecast of the NGDP for it to work, as there are much better economists out there that can help you out with this (Scott Sumner, Lars Christiansen, Marcus Nunes, Nick Rowe, to name a few). What I want to talk about is the case when the NGDP is above target.

These days a NGDP target makes sense, in theory at least, as by some measures current NGDP in the US and the euro area is below some trend. Therefore, a loose monetary policy would help NGDP move to its long run trend.

But there is a problem: NGDP trend might not be constant. Let’s look at the graphs below. I use an H-P filter (purely statistical method) to separate the trend from the cylcle in the NGDP for the euro area and the US. If we use the entire sample we end up with an NGDP that is right on its long term trend at the end of 2011. This, no need for further monetary stimulus.

What’s all the fuss then about NGDP being below trend? Well, if we shorten the sample and apply the HP filter for a data only up to the first quarter of recession we end up with a much higher NGDP long run trend. So, if we compare the current NGDP level with that trend then yes we are below and we need to catch up.

But who says that that is the long run trend for the NGDP? By now we all know that the 2006-2007 period was seen as the “Irrational Exuberance” period. Thus, if we shorten the sample further and apply the HP filter one more time we end up with a long term trend that is closer to the one which uses the data set up to the end of 2011. Thus, we could assume that the period of 2006-2008 was a period of overheating fueled by a too loose monetary policy and thus more of an anomaly than a normal period.

There is one more thing that I find odd about the NGDP targeting . IF we look at the period up to 2008 we see that the NGDP level was barely above its long run trend at the end of 2008. By this measure the economy was not overheating at that time and thus it would have not required a tight monetary policy. But we all know that the economies of both US and euro area were overheating by 2007, as consumer prices correctly signaled.

Let’s forget all this about shifting trends and assume that there is one trend and the NGDP level is above it (i.e. the economy is overheating). Then, monetary policy needs to actually drive the economy in recession to bring the NGDP level below target,not at target but below, because it is the only way to bring NGDP at target in the future. After all we have witnessed policy makers do since 2007 do we think for one moment that they will allow monetary policy to push the economy in recession when things are “good”? What if NGDP level is above target right in the middle of an election year. What are the odds that central banks will tighten monetary policy in those conditions? I venture to say: slim to none.

While I think NGDP level is the wrong target for monetary policy there is one characteristic of this regime that makes sense to be adopted by the one targeting prices: the level. If there is something that would improve IT is to shift from inflation to price level targeting (PT) (see Svensson 1996 for more details). The main reason is that under the IT regime bygones are bygones and in the PT this is not true.

What does this mean? Well in the current IT regime all the ECB has to do is to forecast inflation below target in the future. It does not have to deliver, as we see today, as long as it keeps forecasting lower inflation, i.e. bygones are bygones. But in the PT regime this is not possible. If the price level is above its target then monetary policy has to actually deliver lower price level and not just a forecast of that, in order for price to be on target in the future. Of course, the problem of trend shifts (due to exogenous reasons) remains and it will create some interesting challenge for the policy makers.


17 thoughts on “Central banks should target the price level not the NGDP

  1. de de ce trebuie sa avem inflatie? In fond si la urma urmei.. inflatie insemna taxare ascunsa…. mutatul puterii de cumparare de la o categorie sociala la alta…. cu efecte profund negative capitalului privat si tehnologizarii… eu tot nu inteleg cum oameni seriosi pot veni in fata publicului cu afirmatii gen.. mutatul puterii de cumparare de la o categorie sociala la alta poate crea crestere economica….

  2. @i-conomics
    tocmai am comentat un articol al D-lui Croitoru care sustinea ca ar trebui sa tintim o inflatie moderata nu una scazuta. Asdar, exista inca opinii care sustin ca inflatia este benefica intr-o economie. La sfarsitul saptamanii o sa revin cu parte a doua.

  3. 1. The so-called “witch-hunt” against your beloved inflation targeting is fully justified – since it handles negative supply shocks in a disastrous manner.

    2. Those extrapolated graphs that you keep on posting are extremely dishonest – you really should know better.

    3. “we all know that the economies of both US and euro area were overheating by 2007, as consumer prices correctly signaled”

    No, WE DON’T. Prove it !

    But overall, I see this discussion as a step in the right direction.
    I don’t know why it took so long to recognize that it’s not just the rate at which indicators change that matters – their level is also important.

    1. @Daniel
      Did you read the title of my post? I propose price level targeting not IT.
      My graphs are not more dishonest than the ones that post a linear trend. As we do not measure the potential GDP it means that it can be anything.
      I do not need to prove the overheating, the crash and burn that followed proves it for me.

      Still, can you please let me know how would you bring NGDP back to its long term linear trend once it overshoots?

      IT was needed as a step towards PLT from very high levels of inflation.

      Si special pentru tine, uite de cand ma intereseaza subiectul:2002

      1. Florin,

        Desi e posibil sa fi sunat asa, intentia mea nu era sa iti contest competenta si experienta (serios).

        “I do not need to prove the overheating, the crash and burn that followed proves it for me.”

        Does not compute – have you converted to Austrianism ?

        Last time I checked, the “crash and burn” was/is caused by an aggregate demand shortfall.

      2. @Daniel
        Cred ca nu ingteleg unde vrei sa ajungi. Este ipoteza ta ca in 2007 economiile SUA, UE, UK si chiar Romania cresteau aprooape de potential?
        Referitor la boom and bust si the demand shortfall a fost un fenomen in sine sau a fost raspunsul la un soc?

        Sunt de acrod ca ex ante este foarte greu sa identifici o perioada de “overheating” dar ex post este mai usor de identificat. Istoric, cresterea rapida a preturilor transmitea acest semnal. De fapt de aceea eu sustin foarte mult ca este nevoie de o tinta care include preturile pentru ca rolul lor este acela de a trimite semnale in economie.

        Revenind la NGDP, problema mea principala este legata de modul cum va functiona. Dupa cum am mai spus ar fi interesant daca o tara ar adopta o asemena politica monetara. Dar pe hartie, cel putin pentru mine, tintirea nivelului PIB-ului este inferioara unei politci monetare care tinteste nivelul preturilor.

      3. @Daniel

        De la Scott Sumner referitor la trend-ul pe care tu spuneai ca eu il prezint eronat 🙂
        2. But does it still make sense to go back to the pre-2008 trend line? Probably not, recently I’ve been calling on the Fed to go about 1/3 of the way back to that trend line, and then start a new policy trajectory (hopefully explicit in this case.) Obviously that’s a subjective judgment, which weighs the costs and benefits of a bit more stimulus now. In a perfect world the Fed would have an explicit NGDP target trajectory, and we wouldn’t have to make those sorts of discretionary decisions. But the fact is that the Fed currently uses discretion, and hence ANY ADVICE that any macroeconomist gives the Fed is inherently discretionary.

  4. Daniel,

    “Ti-e familiara distinctia intre inflatie “supply-side” si inflatie “demand-side” ?” DA! Dar tie iti sunt familiare cauzele pe termen mediu lung la aceste doua tipuri de inflatie? Nu cumva au de a face tot cu tipartnitza fie ea baza monetara sau masa monetara crescuta?

  5. What about debt targeting?
    Dupa mine orice discutie legata de stimularea economiei prin NGDP vs IT/PT ar trebui sa abordeze si problema nivelului datoriei private si/sau publice.

    De ce Japonia cu o datorie publica de 200% din PIB nu prea reuseste sa genereze nici crestere economica nici inflatie? Banca centrala a Japoniei ar trebui sa aiba o atitudine mai agresiva in acest context? Sa cumpere si mai multe active financiare si sa incurajeze astfel guvernul japonez sa-si mareasca chelutielile? Probabil ca s-ar genera in acest mod o inflatie mai considerabila, insa va folosi aceasta la cresterea economica? Sau populatia/companiile vor deveni astfel si mai ingrijorate cu privire la datoria publica si la posibilele repercursiuni economice si astfel vor consuma/investi mai putin?

    1. @sorin

      Teoretic debt ar trebui sa fie limitat de realtia deficit inflatie. Un debt mare ar duce la infaltie atunci o politica monetara care limiteaza inflatia ar trebui sa puna o limita pe debt. Dar, problema mare cu tintirea infaltiei este ca nu corecteaza greselile din trecut. Doar promite ca inflatia va fi in tinta in viitor. Astfel nu are cum sa reduca stocul datoriei decat sa limiteze cresterea.

      O sa revin cu un post in Romana despre tintirea infaltiei versus tintirea nivelului preturilor.

      1. Well, n-as fi asa sigur: sa nu uitam ca in 2007 atat in Romania cat si in SUA rata inflatiei facea noi minime in timp ce datoria privata se afla intr-o continua ascensiune. Anul urmator inflatia a inceput sa creasca dar in acelasi timp a venit si criza asa ca in acel moment bancile centrale nu-si mai puneau problema sa creasca dobanda, ci dimpotriva sa o scada (ma rog, poate cu exceptia BCE si BNR care au fost reticiente in a scadea dobanzile in prima faza a crizei). In opinia mea nivelul ridicat al datoriei (raportata la PIB) a fost principala cauza a crizei iar politica monetara nu a reusit sa o previna si s-ar putea ca, si daca ar fi aplicat oricare din sistemele monetare propuse (PT, IT, NGDP), tot nu ar fi putut sa o previna.

        In concluzie eu zic ca ar trebui sa se insiste ceva mai mult pe acest subiect al nivelului datoriei.

      2. @Sorin
        Eu nu am spus ca este asa (apropo rata inflatiei nu face minime este peste tinta :)) am spus ca asa ar trebui sa fie.
        Politica monetara, si implicit alegea tintei, trebuie sa stabilizeze in final actvitiatea economica. De exemplu, exista studii, si date, care arata ca o politica monetara care in acelasi timp incearca sa stabilizeze preturile si cursul de schimb va creste voltilitatea actvitatii economice (de aici aversiunea mea la interventii). Alegerea tintei trebuie sa tina cont de acest lucru. Atunci cand tintesti datoria publica cu politica monetara trebuie sa ai in vedere ce instrumente folosesti.

        Cred ca tinta datoriei publice este mult mai bine sa fie in seama ministerului de finante. O interbare interesanta este: care este nivelul optim al datoriei publice?

      3. O intrebare interesanta intr-adevar. Din cate imi amintesc se incearca cateva raspunsuri la aceasta in cartea scrisa de C. M. Reinhart & K. Rogoff, “This Time Is Different: Eight Centuries of Financial Folly”.

        In ceea ce priveste ministerul de finante, cred ca aceasta institutie nu este preocupata la modul serios de problema datoriei atat timp cat este sustinuta de banca centrala prin dobanzi mici si/sau cumparari de tiluri de stat.

      4. @Sorin
        Cartea e foarte buna pentru ca arata ca si un nivel mic al daotriei publice poate sa fie daunator – dar nu se uita la nivelul optim. In plus arata ca se poate face default intern, similar cu cel din Rommania, cand banca centrala finanteaza indirect datoria publica. De fapt in Romania a fost chiar mai transaparent falimentul folosind bani de la FMI pentru plata cheltuielilor curente.

        Ai dreptate, atata timp cat MF se poate imprumuta nu are niciun interes sa se reformeze.

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