Do we have a problem if it works?

Recently I have become more positive on the outlook for the European and US economies. It seems like the ECB has finally recognised that it need to ease monetary policy to avoid a deflationary disaster and judging from the development in broad monetary aggregates in the US there are signs that things are also moving in the right direction in the US economy.

If investors and consumers are jumping on the happy-go-lucky bandwagon then we might even see the money velocity in the US and the euro zone  begin to inch up. If both broad money supply growth is picking up and velocity would be inching upward then nominal GDP and inflation would also be accelerating and as any Market Monetarist will tell you expectations are key so the recovery could be very swift if market participants start to think that central banks are willing to accept as short-term pick up inflation to achieve a higher level of NGDP.

Lets be really optimistic and say that US inflation jumps to 5% in the coming half year and real GDP also increases to 5% (there are no signs that that is happening). That would give us 10% NGDP growth and we would finally be closing the “NGDP gap” and start to return to the pre-crisis trend. What would happen in that situation? Well, some of us would happy, but there is no doubt that the fears of “runaway inflation” would increase. As somebody asked me the other day “will you be able to stop inflation getting out of control if you have 2 years in a row with 5 or 7% inflation?” My answer was “Clearly!”, but I must also admit that I am more worried than that answer reflected.

Hence, in my view there is a real risk that if monetary policy is eased in the present “stealth” fashion then it will be much harder to anchor expectations – and more importantly it might be harder to get policy makers back to the idea that high inflation is bad. No, please do remember that we are not inflationists. Inflation is bad – at least demand inflation is bad.

Therefore, I think that even if nominal GDP growth starts to pick up I think is extremely important that we keep arguing in favour of NGDP level targeting. We don’t want “stimulus” to bring us out of the present mess. No, we want a monetary regime that ensures us against ever to get into this situation again. So yes, we should clearly argue for monetary easing now, but it is much more important that sound monetary regimes are implemented.

Lets say I had the choice between increasing euro NGDP with 15% right now but also maintain the overall present monetary regime in Europe (with all its faults) or have a monetary regime based NGDP level targeting (but from present levels) then I surely would prefer the later.

Leave a comment


  1. “Any system which gives so much power and so much discretion to a few men, [so] that mistakes — excusable or not — can have such far reaching effects, is a bad system”

  2. John Johnson

     /  February 10, 2012

    Thanks, Lars. You addressed a concern of mine, minor, to be sure, at present, but almost certain to loom larger as the NGDP gap begins to close. One can’t but worry, since I fear that, once the NGDP “freight train” gets rolling, it will be hard to slow down, particularly since Western central banks do not yet seem convinced of the worth of an NGDP rule (judging from the press conferences I read from the ECB, the FED, and the JCB). Needless to say, they manifest little or no awareness of how such a rule could be safely implemented without sparking runaway inflation. I see occasional references to NGDP targetting in the mainstream press (Financial Times, The Economist), but they are little more than phrases. To me, that signifies adoption of such a rule is probably quite a ways off.

    • John, unfortunately NGDP level targeting is not well understood by most people in the financial media. The importance of anchoring expectations is particularly important and even fewer seem to understand that. It therefore also paramount that we keep talking about “rules” rather than “stimulus”. I don’t want stimulus. I want central banks to stop distorting the price system and therefore the overall economy.

  3. Alex Salter

     /  February 10, 2012

    As much as I love NGDP targeting theoretically, I admit I am somewhat skeptical (worried?) about the Fed’s ability to signal credibly an NGDP level target. Obviously if they expand the base enough, eventually inflation expectations will pick up. But the market has to do most of the work, but it will only do the work if it thinks the Fed could do it anyway. What exact mechanism would we envision the Fed using to implement a given dynamic NGDP target?

  4. Benjamin Cole

     /  February 10, 2012

    An excellent blog!

  5. Alex, I think that there are numerous ways the Fed could implement a NGDP level target. I have earlier suggested that it could be done by using a variation of Irving Fischer’s Compensated Dollar Plan, where the Fed could buy a basket of commodities and would do that until NGDP expectations started to pick up. In a recent post I also commented on George Selgin’s ideas for money market reforms in the US. Open Market Operations in reformed money market clearly is also a possibility. But again, I think it is very important that the Fed announce the NGDP target loud and clear. Then I think the market would do most of the lifting itself.

  6. Hi Lars

    According to Ambrose Evans-Pritchard you are very positive about LTRO:

    “This is stealth QE: the impact is dulled because they are not making it clear what they are trying to do, but in the end it may ultimately be as powerful as QE in America and Britain,” said Lars Christensen from Danske Bank.

    Is this a general view among market monetarists? I haven’t seen any comment on LTRO from Sumner. If it doesn’t matter if the central bank buys bonds directly or lends the money to the banks, why didn’t the Fed do the same thing (and maybe avoid some of the criticism they have received from debt monetization)?

  7. Oscar, I am not sure I would say I am “very positive” on LTRO, but I think that it is working in easing monetary conditions in Europe – and that is badly needed. I remain very skeptical that the ECB is so unclear about what it really wants to achieve with it’s policies and I would much prefer that the ECB was targeting the NGDP level rather than a fuzzy inflation target.

    Could the Fed have avoided the fuss about QE? Yes, I think that if the Fed early on had done two things. First it should have announced that it would do unlimited amounts of buying of whatever assets needed to bring NGDP back to the pre-crisis trend. The likely thing is that that would led to a relatively sharp weakening of the dollar and most likely the US stock market would have increased sharply. Both would led to a sharp increase in NGDP – even if the Fed had not done any QE. Second, in line with George Selgin’s recommendation the Fed should have aggressively to get rid of it system of primary dealers and instead have led directly to the market – in a “neo-Bagehotian” fashion and acted as “market maker of last resort”. This is basically what the ECB is now doing (even though one clearly can discuss the details and especially the motives for the ECB’s actions). See more on Selgin’s views here:


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