What's this NGDP Thing?

After years of remaining a theoretical plaything for money nerds like me, nominal GDP targeting has suddenly become a thing.   NGDP targeting has been getting love from economists across the political spectrum, which naturally means laypeople across the spectrum are responding with skepticism. Drudged up from what I remember from Prof. Burdekin's Money and Banking, I present the basics of NGDP targeting:

What is NGDP targeting?

NGDP targeting means that the central bank sets monetary policy to target nominal gross domestic product, that is, GDP that is not adjusted for price level.  The beauty of NGDP targeting is that since both prices and output are part of NGDP, both of these things influence monetary policy even though only one metric is considered.  Either NGDP level, or growth, can be targeted.

Why liberal economists like it: liberal economists tend to be more supportive of considering economic growth, not just inflation, when setting monetary policy.  NGDP targeting naturally includes growth as an input.

Why conservative economists like it: conservative economists tend to prefer simple, transparent rules for monetary policy, as opposed to opaque systems that give broad discretion to policy makers. NGDP targeting is easy to understand and easy to see if policy makers have met their goal.

So how is it different?

The Federal Reserve has what’s called a dual mandate—they are charged with considering both prices and economic output when setting policy.  (Some central banks, like the European Central Bank, are charged with only considering prices.)  The Federal Reserve does not commit to following any particular formula for setting monetary policy, but it is largely believed to behave as if it follows the Taylor Rule, meaning it considers deviations from target inflation rates and target employment rates.   Targeting NGDP would provide the Federal Reserve with a mandate to specifically target deviations from output targets.

There are other things a central bank can consider besides prices, employment, and output when setting policy, such as money growth and asset prices.  A central bank with broad discretion can consider all of these things, but this comes at the cost of making monetary policy decisions less transparent.

But what about QE2??

So where do things like quantitative easing fit into all this? It is important to distinguish between the tools used to set monetary policy and the tools used to implement monetary policy.  Tools used to set monetary policy, such as Taylor Rules, money growth target, or NGDP targeting, tell the central bank whether they need to tighten or loosen policy.  The tools used to implement monetary policy generally remain the same regardless of what policy prescription tool you use.  If interest rates are at zero, and inflation is low and unemployment high, you need quantitative easing to get to your targets.  If interest rates are at zero and NGDP is below target—guess what, you still need quantitative easing to get to your target.

Targeting Growth vs. Level

If you are going to target NGDP, you have to decide whether to target NGDP growth rate or NGDP level. Most of the cool kids in economics prefer level targeting.  Level targeting has the benefit of allowing for catch up periods: after the economy has had a downturn, it natural that it have a period of both higher growth and inflation to catch up to where it would have been pre-downturn.

So let’s do it?

To me, whether NGDP targeting should be implemented actually involves three different questions:

1.       Should GDP be considered when setting monetary policy?  The downside to considering GDP or other factors is that the central bank places less weight on price stability, which is bad if you are an inflation hawk.  The benefit is that drops in GDP often lead drops in inflation or unemployment, so considering GDP can help the central bank adjust to new economic trends more quickly.

2.       Should the central bank target levels rather than growth rates? When it comes to prices, levels are arbitrary—it’s change in prices that matter. That’s the primary logic behind targeting inflation rather than price level.  However, as discussed above, it is natural for an economy that has been sluggish for a while to have a period of higher growth and higher inflation to “catch up” after a downturn, so monetary policy that accommodates this can make sense. This accommodation can actually help end a downturn more quickly—if during a downturn, people know they can expect extra high inflation in the future, they have an incentive to spend more now, stimulating the economy.  The flip side to all this, which I haven’t seen discussed much, is that monetary policy lags the trends a bit.  This sounds great when you are coming out of a recession, but what about when you are coming out of an expansion? Would the people keen to see accommodating monetary policy continue as growth picks up be equally keen to see tight monetary policy stay in place when growth comes to an end?

3.       Should the central bank have a clearly defined rule? The benefit of a rule is that it provides transparency and sets expectations, and expectations are essential for effective monetary policy.  The downside of a rule is less flexibility, and loss of credibility if the central bank fails to meet its targets.

If you answered yes to all of the above, then NGDP level targeting is for you.  Personally, I agree that a central bank with a dual mandate should consider GDP.  However, I think that the central bank should have some flexibility in targeting levels versus growth, and that growth is sometimes the more appropriate metric.   Moreover, I think that a central bank like the Federal Reserve, that has a high level of trust and credibility, has more to lose from committing to a rule like NGDP level targeting than it has to gain, since failure to achieve the target would hurt its credibility.  As it is, the Federal Reserve can consider the policy prescriptions of an NGDP target, while also considering Taylor Rules, asset prices, and other economic data when setting monetary policy.