It is time for BoE to make the 4% NGDP target official

While I do not want to overestimate the effects of Brexit on the UK economy it is clear that last week’s Brexit vote has significantly increased “regime uncertainty” in the UK.

As I earlier have suggested such a spike in regime uncertainty is essentially a negative supply shock, which could turn into a negative demand shock if interest rates are close the the Zero Lower Bound and the central bank is reluctant to undertake quantitative easing.

In the near-term it seems like the biggest risk is not the increase in regime uncertainty itself, but rather the second order effect in the form of a monetary shock (increased money demand and a drop in the natural interest rate below the ZLB).

Furthermore, from a monetary policy perspective there is nothing the central bank – in the case of the UK the Bank of England – can do about a negative supply other than making sure that the nominal interest rate is equal to the natural interest rate.

Therefore, the monetary response to the ‘Brexit shock’ should basically be to ensure that there is not an additional shock from tightening monetary conditions.

So far the signals from the markets have been encouraging 

One of the reasons that I am not overly worried about near to medium-term effects on the UK economy is the signal we are getting from the financial markets – the UK stock markets (denominated in local currency) has fully recovered from the initial shock, market inflation expectations have actually increased and there are no signs of distress in the UK money markets.

That strongly indicates that the initial demand shock is likely to have been more than offset already by an expectation of monetary easing from the Bank of England. Something that BoE governor Mark Carney yesterday confirmed would be the case.

These expectations obviously are reflected in the fact that the pound has dropped sharply and the market now is price in deeper interest rate cuts than before the ‘Brexit shock’.

Looking at the sharp drop in the pound and the increase in the inflation expectations tells us that there has in fact been a negative supply shock. The opposite would have been the case if the shock primarily had been a negative monetary shock (tightening of monetary conditions) – then the pound should have strengthened and inflation should have dropped.

Well done Carney, but lets make it official – BoE should target 4% NGDP growth

So while there might be uncertainty about how big the negative supply shock will be, the market action over the past week strongly indicates that Bank of England is fairly credible and that the markets broadly speaking expect the BoE to ensuring nominal stability.

Hence, so far the Bank of England has done a good job – or rather because BoE was credible before the Brexit shock hit the nominal effects have been rather limited.

But it is not given that BoE automatically will maintain its credibility going forward and I therefore would suggest that the BoE should strengthen its credibility by introducing a 4% Nominal GDP level target (NGDPLT). It would of course be best if the UK government changed BoE’s mandate, but alternatively the BoE could just announce that such target also would ensure the 2% inflation target over the medium term.

In fact there would really not be anything revolutionary about a 4% NGDP level target given what the BoE already has been doing for sometime.

Just take a look at the graph below.


I have earlier suggested that the Federal Reserve de facto since mid-2009 has followed a 4% NGDP level target (even though Yellen seems to have messed that up somewhat).

It seems like the BoE has followed exactly the same rule.  In fact from early 2010 it looks like the BoE – knowingly or unknowingly – has kept NGDP on a rather narrow 4% growth path. This is of course the kind of policy rule Market Monetarists like Scott Sumner, David Beckworth, Marcus Nunes and myself would have suggested.

In fact back in 2011 Scott authored a report – The Case for NGDP Targeting – for the Adam Smith Institute that recommend that the Bank of England should introduce a NGDP level target. Judging from the actual development in UK NGDP the BoE effectively already at that time had started targeting NGDP.

At that time there was also some debate that the UK government should change BoE’s mandate. That unfortunately never happened, but before he was appointed BoE governor expressed some sympathy for the idea.

This is what Mark Carney said in 2012 while he was still Bank of Canada governor:

“.. adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.

when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.

Shortly after making these remarks Mark Carney became Bank of England governor.

So once again – why not just do it? 1) The BoE has already effectively had a 4% NGDP level target since 2010, 2) Mark Carney already has expressed sympathy for the idea, 3) Interest rates are already close to the Zero Lower Bound in the UK.

Finally, a 4% NGDP target would be the best ‘insurance policy’ against an adverse supply shock causing a new negative demand shock – something particularly important given the heightened regime uncertainty on the back of the Brexit vote.

No matter the outcome of the referendum the BoE should ease monetary conditions 

If we use the 4% NGDP “target” as a benchmark for what the BoE should do in the present situation then it is clear that monetary easing is warranted and that would also have been the case even if the outcome for the referendum had been “Remain”.

Hence, particularly over the past year actual NGDP have fallen somewhat short of the 4% target path indicating that monetary conditions have become too tight.

I see two main reasons for this.

First of all, the BoE has failed to offset the deflationary/contractionary impact from the tightening of monetary conditions in the US on the back of the Federal Reserve becoming increasingly hawkish. This is by the way also what have led the pound to become somewhat overvalued (which also helps add some flavour the why the pound has dropped so much over the past week).

Second, the BoE seems to have postponed taking any significant monetary action ahead of the EU referendum and as a consequence the BoE has fallen behind the curve.

As a consequence it is clear that the BoE needs to cut its key policy to zero and likely also would need to re-start quantitative easing. However, the need for QE would be reduced significantly if a NGDP level target was introduced now.

Furthermore, it should be noted that given the sharp drop in the value of the pound over the past week we are likely to see some pickup in headline inflation over the next couple of month and even though the BoE should not react to this – even under the present flexible inflation target – it could nonetheless create some confusion regarding the outlook for monetary easing. Such confusion and potential mis-communication would be less likely under a NGDP level targeting regime.

Just do it Carney!

There is massive uncertainty about how UK-EU negotiations will turn out and the two major political parties in the UK have seen a total leadership collapse so there is enough to worry about in regard to economic policy in the UK so at least monetary policy should be the force that provides certainty and stability.

A 4% NGDP level target would ensure such stability so I dare you Mark Carney – just do it. The new Chancellor of the Exchequer can always put it into law later. After all it is just making what the Bank of England has been doing since 2010 official!

Stanley Fischer – this guy can keep NGDP on a straight line

This is from Reuters:

Stanley Fischer, who led the Bank of Israel for eight years until he stepped down in June, has been asked to be the Federal Reserve’s next vice chair once Janet Yellen takes over as chief of the U.S. central bank, a source familiar with the issue said on Wednesday.

Fischer, 70, is widely respected as one of the world’s top monetary economists. At the Massachusetts Institute of Technology, he once taught current Fed Chairman Ben Bernanke and Mario Draghi, the European Central Bank president.

Yellen, the current Fed vice chair, is expected to win approval from the U.S. Senate next week to take the reins from Bernanke, whose term ends in January.

Fischer, as an American-Israeli, was widely credited with guiding Israel through the global economic crisis with minimal damage. For the Fed, he would offer the fresh perspective of a Fed outsider yet offer some continuity as well.

Good news! Stanley Fischer certainly is qualified for the job. He knows about monetary theory and policy. And even better he used to have some sympathy for nominal income targeting. Just take a look at this quote from his 1995 American Economic Review article “Central Bank Independence Revisited” (I stole this from Evan Soltas):

“In the short run, monetary policy affects both output and inflation, and monetary policy is conducted in the short run–albeit with long-run targets and consequences in mind. Nominal- income-targeting provides an automatic answer to the question of how to combine real income and inflation targets, namely, they should be traded off one-for-one…Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to implya better automatic response of monetary policy to supply shocks…I judge that inflation-targeting is preferable to nominal-income-targeting, provided the target is adjusted for supply shocks.”

While at the Bank of Israel Fischer certainly conducted monetary policy as if he was targeting the level of nominal GDP. Just take a look at the graph below and note the “missing” crisis in 2008.

NGDP Israel

Undoubtedly Fischer had some luck, while at the BoI, and I must also say that I think he from time to time had a problem with his “forward guidance”, but his track-record speaks for itself – while Bank of Israel  governor, Stanley Fischer provided unprecedented nominal stability, something very rare in Israeli economic history. Lets hope he will help do that at the Fed as well.

Did Bennett McCallum run the SNB for the last 20 years?

Which central bank has conducted monetary policy in the best way in the last five years? Among “major” central banks the answer in my view clearly would have to be the SNB – the Swiss central bank.

Any Market Monetarist would of course tell you that you should judge a central bank’s performance on it’s ability to deliver nominal stability – for example hitting an nominal GDP level target. However, for an small very open economy like the Swiss it might make sense to look at Nominal Gross Domestic Demand (NGDD).

This is Swiss NGDD over the past 20 years.

NGDD Switzerland

Notice here how fast the NGDD gap (the difference between the actual NGDD level and the trend) closed after the 2008 shock. Already in 2010 NGDD was brought back to the 1993-trend and has since then NGDD has been kept more or less on the 1993-trend path.

Officially the SNB is not targeting NGDD, but rather “price stability” defined as keeping inflation between 0 and 2%. This has been the official policy since 2000, but at least judging from the actually development the policy might as well have been a policy to keep NGDD on a 2-3% growth path. 

Bennett McCallum style monetary policy is the key to success

So why have the SNB been so successful?

My answer is that the SNB – knowingly or unknowingly – has followed Bennett McCallum’s advice on how central banks in small open economies should conduct monetary policy. Bennett has particularly done research that is relevant to understand how the SNB has been conducting monetary policy over the past 20 years.

First, of all Bennett is a pioneer of NGDP targeting and he was recommending NGDP targeting well-before anybody ever heard of Scott Summer or Market Monetarism.  A difference between Market Monetarists and Bennett’s position is that Market Monetarists generally recommend level targeting, while Bennett (generally) has been recommending growth targeting.

Second, Bennett has always forcefully argued that monetary policy is effective in terms of determining NGDP (or NGDD) also when interest rates are at zero and he has done a lot of work on optimal monetary policy rules at the Zero Lower Bound (See for example here). One obvious policy is quantitative easing. This is what Bennett stressed in his early work on NGDP growth targeting.  Hence, the so-called Mccallum rule is defined in terms the central bank controlling the money base to hit a given NGDP growth target. However, for small open economies Bennett has also done very interesting work on the use of the exchange rate as a monetary policy tool when interest rates are close to zero.

I earlier discussed what Bennett has called a MC rule. According to the MC rule the central bank will basically use interest rates as the key monetary policy rule. However, as the policy interest rate gets close to zero the central bank will start giving guidance on the exchange rate to change monetary conditions. In his models Bennett express the policy instrument (“Monetary Conditions”) as a combination of a weighted average of the nominal exchange rate and a monetary policy interest rate.

SNB’s McCallum rule

My position is that basically we can discribe SNB’s monetary policy over the past 20 years based on these two key McCallum insights – NGDP targeting and the use of a combination of interest rates and the exchange rate as the policy instrument.

To illustrate that I have estimated a simple OLS regression model for Swiss interest rates.

It turns out that it is very to easy to model SNB’s reaction function for the last 20 years. Hence, I can explain 85% of the variation in the Swiss 3-month LIBOR rate since 1996 with only two variables – the nominal effective exchange rate (NEER) and the NGDD gap (the difference between the actual level of Nominal Gross Domestic Demand and the trend level of NGDD). Both variables are expressed in natural logarithms (ln).

The graph below shows the actually 3-month LIBOR rate and the estimated rate.

SNB policy rule

As the graph shows the fit is quite good and account well for the ups and down in Swiss interest rates since 1996 (the model also works fairly well for an even longer period). It should be noted that I have done the model for purely illustrative purposes and I have not tested for causality or the stability of the coefficients in the model. However, overall I think the fit is so good that this is a pretty good account of actual Swiss monetary policy in the last 15-20 years.

I think it is especially notable that once interest rates basically hit zero in early 2010 the SNB initially started to intervene in the currency markets to keep the Swiss franc from strengthening and later – in September 2011 – the SNB moved to put a floor under EUR/CHF at 120 so to completely curb the strengthening of Swiss franc beyond that level. As a result the nominal exchange rate effectively has been flat since September 2011 (after an initial 10% devaluation) despite massive inflows to Switzerland in connection with the euro crisis and rate of expansion in the Swiss money supply has accelerated significantly.

Concluding, Swiss monetary policy has very much been conducted in the spirit of Bennett McCallum – the SNB has effectively targeted (the level of) Nominal Gross Domestic Demand and SNB has effectively used the exchange rate instrument to ease monetary conditions with interest rates at the Zero Lower Bound.

The result is that the Swiss economy only had a very short period of crisis in 2008-9 and the economy has recovered nicely since then. Unfortunately none of the other major central banks of the world have followed the advice from Bennett McCallum and as a result we are still stuck in crisis in both Europe and the US.

PS I am well-aware that the discuss above is a as-if discussion that this is what the SNB has actually said it was doing, but rather that it might as well been officially have had a McCallum set-up.  

PPS If one really wants to do proper econometric research on Swiss monetary policy I think one should run a VAR model on the 3-month LIBOR rate, the NGDD gap and NEER and all of the variables de-trended with a HP-filter. I will leave that to somebody with econometric skills and time than myself. But I doubt it would change much with the conclusions.

Mr. Osborne: “There is a lot of innovative stuff happening around the world”

It is hard not getting just a bit excited about the discussions getting under way in the UK after the coming Bank of England governor Mark Carney basically has endorsed NGDP level targeting. So far the UK government has not given its view on the matter, but it is pretty clear that UK policy makers are aware of the issues. That is good news and today we got a “reply” from the UK government to Carney’s (near) endorsement of NGDP targeting in the form of comments from UK Chancellor George Osborne.

This is from the Daily Telegraph:

The Chancellor said he was “glad” that Mark Carney, the next Governor of the Bank, had raised the prospect of ending central banks’ inflation targets to concentrate more on gross domestic product.

Mr Osborne described the suggestion (NGDP level targeting) as “innovative” and said he was pleased Mr Carney was discussing such ideas.

“There is a debate about the future of monetary policy — not exclusively in the UK, but in many countries. There is a lot of innovative stuff happening around the world,” he said.

“There is a debate going on. I am glad that the future central bank governor of the UK is part of that debate.”

Asked if he was considering making the change suggested by Mr Carney, Mr Osborne said: “There is a debate going on. Any decisions, any future decisions are a matter for government.”

He added: “I have no plans to change the framework. There is a debate going on. I think it’s right there is a debate.”

Mr Osborne said he had had “lots of discussions” with Mr Carney about monetary policy before appointing the Canadian to the Bank of England. But he declined to confirm they had discussed the inflation target, sating the conversations were “private”.

Although he signalled he was open to changing the target, he said that the current inflation target has “served us well” and he would have to be persuaded to changing it.

…A similar debate about nominal GDP targets has been underway for some time, Mr Osborne noted, adding: “It would be a good thing for academia to lead the debate and government to follow.”

This is certainly uplifting. Osborne signals that he don’t necessarily think that NGDP level targeting is a bad idea (it is a great idea!). Obviously for those of us who think NGDP targeting is a great idea it is natural to cheer and scream on Mr. Osborne to get to work on changing the BoE’s mandate immediately. However, for once I will be cautious. I think it makes very good sense for Mr. Osborne to encourage discussion about this issue. Changing a countries monetary regime is an extremely serious matter. Yes, I strongly believe that an NGDP level targeting regime would be preferable to the UK compared to today’s regime, but I also think that the “institutional infrastructure” needs to be sorted out before completely changing the regime.

That said as far as I understand the legal framework (and I am certainly no specialist on this) the Chancellor actually can change the BoE’s mandate simply by sending a letter to the Bank of England governor. So with the stroke of his pen Mr. Osborne could make the  UK first country in the world that had an NGDP targeting regime. I would compare such a policy move to the decision in 1931 that took the UK of the gold standard. That saved the country from deflation and depression. Mr. Osborne could write himself in to the economic history books by showing the same kind of resolve as the UK government did in 1931.

Mr. Osborne deserves a lot of credit for encouraging debate

While I do not agree that the UK’s inflation targeting regime has “served the UK well” I would also say that the UK could have had much worse regimes – just think of monetary policy in the UK in the 1970s or the failed experiment with pegging the pound with with the ERM in the early 1990s.  The is no doubt that an inflation targeting regime is preferable to both alternatives – discretionary inflationary madness or a misaligned fixed exchange rate regime.

However, the inflation targeting regime in the UK likely added to fueling the UK housing bubble (sorry Scott – there was a UK housing bubble) and it has certainly made the crisis much deeper since 2008. An NGDP level targeting regime would have meant that UK monetary policy would have been tighter in the “boom year” just prior to 2008, but also easier over the past four years (but maybe with much less QE!). That would have led to more conservative fiscal policies, more prudent lending policies from the commercial banks and a small housing bubble prior to 2008 and most defiantly much stronger public finances and less unemployment after 2008. Who would seriously oppose such a monetary policy regime?

So I certainly think that an NGDP level targeting regime would have served the UK better than the inflation targeting regime. But Osborne is right – there need to be a debate about this and think the Mr. Osborne deserves a lot of credit for calling for such a debate instead of just declaring that nothing can ever be changed. That is wonderfully refreshing compared to the horrors of the (lack of) debate about monetary policy in Continental Europe (the euro zone…)


I just looked at the NGDP growth rate of 143 countries

Xavier Sala-I-Martin once wrote a paper called “I just ran two million regressions”. I can’t do quite as good, but I nonetheless have had a look at the nominal GDP growth of 143 countries since 1990. My “project” is to see whether there is a correlation between the growth rate of NGDP and the volatility of NGDP. We know from inflation history that there is a pretty close positive correlation between higher inflation and higher volatility in inflation. My expectation was that that would also be the case for NGDP and NGDP volatility (measured as the standard deviation of yearly NGDP growth across 143 different countries).

But more important I wanted to see whether we could say what would be the “optimal” growth rate of NGDP. By “optimal” I (here) understand the rate of NGDP growth that minimizes the volatility of NGDP growth and hence increases the predictability of NGDP growth.

Let’s first look at the data in the must raw form. This is a plot of the average yearly growth rate of NGDP in the 143 countries against the standard deviation of the NGDP growth rate in the same countries. I have split the period 1990-2011 into four sub-periods 1990-1995, 1995-2000, 2000-2007 and 2007-2011. That gives us four observations per country – nearly 600 observations.

The graph is pretty clear – as with inflation there is a pretty clear positive correlation between the level of NGDP growth and the standard deviation of NGDP growth.

Hence, there is a clear cost of higher NGDP in the form of a more volatile NGDP development.

Therefore an NGDP target of 3 or 5% growth clearly is preferable to an NGDP target of for example 10 or 100%.

However, if lower NGDP growth reduces the volatility of NGDP why not target -10% NGDP growth or lower?

To examine this issue I take a closer look at the data.

The graph below zoom in on countries (and periods) with an average growth rate of NGDP below 30%.

Again we see the clear picture that higher NGDP growth leads to higher NGDP volatility – and this also goes for relatively low rates of NGDP growth. Hence, it is not only in hyperinflation scenarios that this is the case.

As the graph shows if we go from an NGDP growth rate of 0-6% to 14-20% the volatility of NGDP growth doubles!

However, the graph also shows that the relationship is not linear. In fact if NGDP growth drops below zero – as have been the case in many countries since 2008 – then the volatility increases.

The graph also shows that there historically has not been any significant difference in NGDP volatility countries with NGDP growth of 0-2% or 4-5%.

The graph should make Scott Sumner happy as Scott has been arguing that the Federal Reserve should target 5% growth (level targeting). Historically NGDP growth of 5% has minimized the variance of NGDP growth and there would probably be little to gain – in terms of reducing NGDP volatility – by targeting a lower rate of NGDP growth. However, there would clearly be a cost of for example targeting a higher growth rate of for example 10%.

I think there is important lessons to draw from the graphs below. First and foremost that an NGDP growth target between 0% and 6% is preferable to higher or lower growth rates. But it should also be remembered that this is a very simple analysis and we could certainly lear a lot more from studying the country specific data closer, but all in all I don’t think Scott is making a major mistake when he is arguing in favour of a 5% NGDP (level) target in the US.

PS Forgive me for using volatility and standard deviation synonymously, but I am sure you get the drift. And please don’t kill me for saying that minimizing the volatility of NGDP is “optimal” – that is just a figure of speech.

PPS I really didn’t do the calculations on my own – I got quite a bit of help from my young and clever colleague Mikael Olai Milhøj.

UPDATE: Another young and clever colleague of mine Jens Pedersen noted that the logic of our results actually mean that a country like China with a trend growth rate of real GDP well above 6% should de facto be a deflation target’er to minimize NGDP volatility. This is what the data is saying – at least indirectly – but I am not sure that I am ready to argue that. I am however pretty sure that George Selgin would tell me that that is in fact what China should do.

“Money neutrality” – normative rather than positive

When we study macroeconomic theory we are that we are taught about “money neutrality”. Normally money neutrality is seen as a certain feature of a given model. In traditional monetarist models monetary policy is said to be neutral in the long run, but not in the short run, while in Real Business Cycle (RBC) models money is (normally) said to be neutral in both the long and the short run. In that sense “money neutrality” can be said to be a positive (rather than as normative) concept, which mostly is dependent on the assumptions in the models about degree of price and wage rigidity.

As a positive concept money is said to be neutral when changes in the money supply only impacts nominal variables such as prices, nominal GDP, wages and the exchange rates, but has no real variables such are real GDP and employment. However, I would suggest a different interpretation of money neutrality and that is as a normative concept.

Monetary policy should ensure money neutrality

Normally the discussion of money neutrality completely disregard the model assumptions about the monetary policy rule. However, in my view the assumption about the monetary policy rule is crucial to whether money is neutral or not.

Hayek already discussed this in classic book on business cycle theory Prices and Production in 1931 – I quote here from Greg Ransom’s excellent blog “Taking Hayek Serious”:

“In order to preserve, in a money economy, the tendencies towards a stage of equilibrium which are described by general economic theory, it would be necessary to secure the existence of all the conditions, which the theory of neutral money has to establish. It is however very probable that this is practically impossible. It will be necessary to take into account the fact that the existence of a generally used medium of exchange will always lead to the existence of long-term contracts in terms of this medium of exchange, which will have been concluded in the expectation of a certain future price level. It may further be necessary to take into account the fact that many other prices possess a considerable degree of rigidity and will be particularly difficult to reduce. All these ” frictions” which obstruct the smooth adaptation of the price system to changed conditions, which would be necessary if the money supply were to be kept neutral, are of course of the greatest importance for all practical problems of monetary policy. And it may be necessary to seek for a compromise between two aims which can be realized only alternatively: the greatest possible realization of the forces working toward a state of equilibrium, and the avoidance of excessive frictional resistance.  But it is important to realize fully that in this case the elimination of the active influence of money [on all relative prices, the time structure of production, and the relations between production, consumption, savings and investment], has ceased to be the only, or even a fully realizable, purpose of monetary policy. ”

The true relationship between the theoretical concept of neutral money, and the practical ideal of monetary policy is, therefore, that the former provides one criterion for judging the latter; the degree to which a concrete system approaches the condition of neutrality is one and perhaps the most important, but not the only criterion by which one has to judge the appropriateness of a given course of policy. It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, firstly, the total money stream remained constant, and secondly, all prices were completely flexible, and, thirdly, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.”

Hence according to Hayek monetary policy should ensure monetary neutrality, which is “a stage of equilibrium which are described by general economic theory”. In Prices and Production Hayek describes this in terms of a Walrasian general equilibrium. Therefore, the monetary policy should not distort relative prices and hence monetary policy should be conducted in a way to ensure that relative prices are as close as possible to what they would have been in a world with no money and no frictions – the Walrasian economy.

As I have discussed in a numerous posts before such a policy is NGDP level targeting. See for example herehere and here.

And this is why the RBC model worked fine during the Great Moderation

If we instead think of monetary policy as a normative concept then it so much more obvious why monetary policy suddenly has become so central in all macroeconomic discussions the last four years and why it did not seem to play any role during the Great Moderation.

Hence, during the Great Moderation US monetary policy was conducted as if the Federal Reserve had an NGDP level targeting. That – broadly speaking – ensured money neutrality and as a consequence the US economy resembled the Walrasian ideal. In this world real GDP would more or less move up and down with productivity shocks and other supply shocks and the prices level would move inversely to these shocks. This pretty much is the Real Business Cycle model. This model is a very useful model when the central bank gets it right, but the when the central bank fails the RBC is pretty useless.

Since 2008 monetary policy has no longer followed ensured nominal stability and as a result we have moved away from the Walrasian ideal and today the US economy therefore better can be described as something that resembles a traditional monetarist model, where money is no longer neutral. What have changed is not the structures of the US economy or the degree of rigidities in the US product and labour markets, but rather the fed’s conduct of monetary policy.

This also illustrates why the causality seemed to be running from prices and NGDP to money during the Great Moderation, but now the causality seem to have become (traditional) monetarist again and money supply data once again seems to be an useful indicator of future changes in NGDP and prices.

Woodford on NGDP targeting and Friedman

Michael Woodford’s Jackson Hole paper is a goldmine. I haven’t read all of it, but I just want to share this quote:

“Essentially, the nominal GDP target path represents a compromise between the aspiration to choose a target that would achieve an ideal equilibrium if correctly understood and the need to pick a target that can be widely understood and can be implemented in a way that allows for verification of the central bank’s pursuit of its alleged target, in the spirit of Milton Friedman’s celebrated proposal of a constant growth rate for a monetary aggregate. Indeed, it can be viewed as a modern version of Friedman’s “k-percent rule” proposal, in which the variable that Friedman actually cared about stabilizing (the growth rate of nominal income) replaces the monetary aggregate that he proposed as a better proximate target, on the ground that the Fed had much more direct control over the money supply. On the one hand, the Fed’s ability to directly control broad monetary aggregates (the ones more directly related to nominal income in the way that Friedman assumed) can no longer be taken for granted, under current conditions; and on the other hand, modern methods of forecast targeting make a commitment to the pursuit of a target defined in terms of variables that are not under the short-run control of the central bank more credible. Under these circumstances, a case can be made that a nominal GDP target path would remain true to Friedman’s fundamental concerns.”

Exactly! NGDP targeting is exactly in the spirit of Friedman.

And Woodford goes on to quote one of the founding fathers of Market Monetarism:

“See, for example, (David) Beckworth (2011) for an argument to this effect. Beckworth notes that Friedman (2003) praised the accuracy of “the Fed’s thermostat,” for having reduced M2 growth during the period of increasing “velocity” in 1988-1997, and then increased M2 growth by several percent- age points during a period of decreasing velocity in 1997-2003. One might conclude that Friedman valued successful stabilization of nominal GDP growth more than strict fidelity to a “k-percent rule.”

See David’s take on Woodford here and here is what Scott Sumner has to say.

Related posts:
Friedman provided a theory for NGDP targeting
Michael Woodford endorses NGDP level targeting

Michael Woodford endorses NGDP level targeting

Here is from Bloomberg:

Central bankers should adopt a clear policy goal, such as the path for nominal gross domestic product, to make remaining easing options more effective under the limits of near-zero interest rates, according to Michael Woodford, a professor of political economy at Columbia University.

Such criteria would increase the impact of efforts to reset public expectations for interest rate policy, such as asset-purchases, Woodford said. Federal Reserve policy makers have kept the benchmark rate near zero since December 2008 and this month reiterated a plan to keep borrowing costs at record lows through at least late 2014.

“A more useful form of forward guidance, I believe, would be one that emphasizes the target criterion that will be used to determine when it is appropriate to raise the federal funds rate target above its current level, rather than estimates of the ‘lift-off’ date,” Woodford said in a paper presented today at the Fed’s annual symposium in Jackson HoleWyoming.

A pledge to restore nominal GDP “to the trend path it had been on up until the fall of 2008” would “make it clear that policy will have to remain looser in the near term” than indicated by the Taylor rule, he said. It would also “provide assurance that the unusually stimulative current policy stance does not imply any intention to tolerate continuing inflation above the Fed’s declared long-run inflation target.”

“But if a central bank’s intention in announcing such purchases is to send such a signal, the signal would seem more likely to have the desired effect if accompanied by explicit forward guidance, rather than regarded as a substitute for it,” Woodford said.

“A more logical policy would rely on a combination of commitment to a clear target criterion to guide future decisions about interest-rate policy with immediate policy actions that should stimulate spending immediately without relying too much on expectational channels,” Woodford said.

The Fed has carried out two rounds of bond purchases known as quantitative easing to reduce borrowing costs. In the first round starting in 2008, the Fed bought $1.25 trillion of mortgage-backed securities, $175 billion of federal agency debt and $300 billion of Treasuries. In the second round, announced in November 2010, the Fed bought $600 billion of Treasuries.

Policies that target specific credit areas, such as buying mortgage-backed securities, or the Bank of England’s Funding for Lending Scheme, may be more effective at boosting spending, though they are “more properly” viewed as fiscal as opposed to monetary stimulus, he said.

Combining central bankers’ nominal GDP target would also “increase the bang for the buck from fiscal stimulus” while limiting inflation concerns, Woodford said. “The most obvious recipe for success is one that requires coordination between the monetary and the fiscal authorities.”

Lets just say I agree with the policy recommendation – even though I certainly do not think US monetary policy is accommodative just because the fed funds rate is low.

Imagine if the ECB would host a conference where somebody would recommend NGDP level targeting…

Here is Woodford’s paper Methods of Policy Accommodation at the Interest-Rate Lower Bound

Update: My fellow Market Monetarists David Beckworth (who is quoted in Woodford’s paper) and Marcus Nunes also comment on Woodford.

NGDP level targeting – the true Free Market alternative (we try again)

Most of the blogging Market Monetarists have their roots in a strong free market tradition and nearly all of us would probably describe ourselves as libertarians or classical liberal economists who believe that economic allocation is best left to market forces. Therefore most of us would also tend to agree with general free market positions regarding for example trade restrictions or minimum wages and generally consider government intervention in the economy as harmful.

I think that NGDP targeting is totally consistent with these general free market positions – in fact I believe that NGDP targeting is the monetary policy regime which best ensures well-functioning and undistorted free markets. I am here leaving aside the other obvious alternative, which is free banking, which my readers would know that I have considerable sympathy for.

However, while NGDP targeting to me is the true free market alternative this is certainly not the common view among free market oriented economists. In fact I find that most of the economists who I would normally agree with on other issues such as labour market policies or trade policy tend to oppose NGDP targeting. In fact most libertarian and conservative economists seem to think of NGDP targeting as some kind of quasi-keynesian position. Below I will argue why this perception of NGDP targeting is wrong and why libertarians and conservatives should embrace NGDP targeting as the true free market alternative.

Why is NGDP targeting the true free market alternative?

I see six key reasons why NGDP level targeting is the true free market alternative:

1) NGDP targeting is ”neutral” – hence unlike under for example inflation targeting NGDPLT do not distort relative prices – monetary policy “ignores” supply shocks.
2) NGDP targeting will not distort the saving-investment decision – both George Selgin and David Eagle argue this very forcefully.
3) NGDP targeting ”emulates” the Free Banking allocative outcome.
4) Level targeting minimizes the amount of discretion and maximises the amount of accountability in the conduct of monetary policy. Central banks cannot get away with “forgetting” about past mistakes. Under NGDP level targeting there is no letting bygones-be-bygones.
5) A futures based NGDP targeting regime will effective remove all discretion in monetary policy.
6) NGDP targeting is likely to make the central bank “smaller” than under the present regime(s). As NGDP targeting is likely to mean that the markets will do a lot of the lifting in terms of implementing monetary policy the money base would likely need to be expanded much less in the event of a negative shock to money velocity than is the case under the present regimes in for example the US or the euro zone. Under NGDP targeting nobody would be calling for QE3 in the US at the moment – because it would not be necessary as the markets would have fixed the problem.

So why are so many libertarians and conservatives sceptical about NGDP targeting?

Common misunderstandings:

1) NGDP targeting is a form of “countercyclical Keynesian policy”. However, Market Monetarists generally see recessions as a monetary phenomenon, hence monetary policy is not supposed to be countercyclical – it is supposed to be “neutral” and avoid “generating” recessions. NGDP level targeting ensures that.
2) Often the GDP in NGDP is perceived to be real GDP. However, NGDP targeting does not target RGDP. NGDP targeting is likely to stabilise RGDP as monetary shocks are minimized, but unlike for example inflation targeting the central bank will NOT react to supply shocks and as such NGDP targeting means significantly less “interference” with the natural order of things than inflation targeting.
3) NGDP targeting is discretionary. On the contrary NGDP targeting is extremely ruled based, however, this perception is probably a result of market monetarists call for easier monetary policy in the present situation in the US and the euro zone.
4) Inflation will be higher under NGDP targeting. This is obviously wrong. Over the long-run the central bank can choose whatever inflation rate it wants. If the central bank wants 2% inflation as long-term target then it will choose an NGDP growth path, which is compatible which this. If the long-term growth rate of real GDP is 2% then the central bank should target 4% NGDP growth path. This will ensure 2% inflation in the long run.

Another issue that might be distorting the discussion of NGDP targeting is the perception of the reasons for the Great Recession. Even many libertarian and conservative economists think that the present crisis is a result of some kind of “market disorder” – either due to the “natural instability” of markets (“animal spirits”) or due to excessively easy monetary policy in the years prior to the crisis. The proponents of these positions tend to think that NGDP targeting (which would mean monetary easing in the present situation) is some kind of a “bail out” of investors who have taken excessive risks.

Obviously this is not the case. In fact NGDP targeting would mean that central bank would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bail out clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.

NGDP level targeting as a privatization strategy

As I argue above there are clear similarities between the allocative outcome under Free Banking – hence a fully privatized money supply – and NGDP targeting. In fact I believe that NGDP level targeting might very well be seen as part of a privatization strategy. (I have argued that before – see here)

Hence, a futures based NGDP targeting regime would basically replace the central bank with a computer in the sense that there would be no discretionary decisions at all in the conduct of monetary policy. In that sense the futures based NGDP targeting regime would be similar to a currency board, but instead of “pegging” monetary policy to a foreign currency monetary policy would be “pegged” to the market expectation of future nominal GDP. This would seriously limit the discretionary powers of central banks and a truly futures based NGDP targeting regime in my view would only be one small step away from Free Banking. This is also why I do not see any conflict between advocating NGDP level targeting and Free Banking. This of course is something, which is fully recognised by Free Banking proponents such as George Selgin, Larry White and Steve Horwitz.

PS this is no the first time I try to convince libertarians and conservatives that NGDP level targeting is the true free market alternative. See my first attempt here.


Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Update (July 23 2012): Scott Sumner once again tries to convince “conservatives” that monetary easing is the “right” position. I agree, but I predict that Scott will fail once again because he argue in terms of “stimulus” rather than in terms of rules.

The Fed can hit any NGDP target

I hate getting into debates where different bloggers go back and forth forever and never reach any conclusion. I am not blogging to get into debates, however, I must admit that Steven Williamson’s recent posts on NGDP level targeting have provoked me quite a bit.

In his first post Williamson makes a number of claims, which I find highly flawed. However, Scott Sumner has already at length addressed most of these issues in a reply to Williamson so I don’t want to get into that (and as you guessed I am fully in agreement with Scott). However, Williamson’s reply to Scott is not less flawed than his initial post. Again I don’t want to go through the whole thing. However, one statement that Williamson makes I think is a very common mistake and I therefore think a comment is in order. Here is Williamson:

“The key problem under the current circumstances is that you can’t just announce an arbitrary NGDP target and hit it with wishful thinking. The Fed needs some tools, and in spite of what Ben Bernanke says, it doesn’t have them.”

This is a very odd comment coming from somebody who calls himself a (New) Monetarist. It is at the core of monetarism in the sense of Friedman, Brunner, Meltzer, Cagan, Schwartz, Warburton and Yeager etc. that nominal GDP is determined by the central bank and no monetarist has ever acknowledged that there is a liquidity trap. Williamson claims that he does not agree with everything Friedman said, but I wonder what Friedman said he agrees with. If you don’t believe that NGDP is determined by the central bank then it makes absolutely no sense to call yourself a monetarist.

Furthermore, if you don’t think that the Fed can hit an NGDP target how could you think it could hit an inflation target? Both changes in NGDP and in prices are monetary phenomena.

Anyway, let’s get back to the question whether the central bank can hit an NGDP target and what instruments could be used to hit that target.

The simplest way to do it is actually to use the exchange rate channel. Let’s assume that the Federal Reserve wants to increase the US NGDP level by 15% and that it wants to do it by the end of 2013.

Scott has suggested using NGDP futures to hit the NGDP target, but let’s assume that is too complicated to understand for the critics and the Fed. Instead the Fed will survey professional forecasters about their expectations for the level of NGDP by the end of 2013. The Fed will then announce that as long as the “consensus” forecast for NGDP is below the target the Fed will step up monetary easing. The Fed will do the survey once a month.

Let’s start out with the first announcement under this new regime. Initially the forecasters are skeptical and forecast NGDP to be 12% below target. As a consequence the Fed announces a Swiss style exchange target. It simply announces that it will intervene in the FX market buying unlimited amounts of foreign currency until the US dollar has weakened 20% in nominal effective terms (and yes, the Fed has the instruments to do that – it has the printing press to print dollars). I am pretty sure that Williamson would agree that that directly would increase US NGDP (if not I would love to see his model…).

The following month the forecasters will likely have moved their forecasts for NGDP closer to the target level. But we might still have too low a level of forecasted NGDP. Therefore, the Fed will the following month announce a further “devaluation” by lets say 5%. The process will continue until the forecasted level for NGDP equals the target level. If the consensus forecast starts to overshoot the target the Fed will simply announce that it will reverse the process and revalue the dollar.

Therefore there is certainly no reason to argue 1) that the Fed can not hit any NGDP target 2) that the Fed does not have an instrument. The exchange rate channel can easily do the job. Furthermore, if the Fed announces this policy then it is very likely that the market will be doing most of the lifting. The dollar would automatically appreciate and depreciate until the market expectations are equal to the NGDP target.

If you have heard all this before then it is because this a variation of Irving Fisher’s compensated dollar plan and Lars E. O. Svensson’s foolproof way out of a liquidity trap. And yes, I have previously suggested this for small open economies, but the Fed could easily use the same method to hit a given NGDP target.

Update: I should note that the example above is exactly that – an example. I use the example to illustrate that a central bank can always increase NGDP and that the exchange rate channel is an effective tool to achieve this goal. However, the numbers mentioned in my post are purely “fictional” and again it example rather than a policy recommendation. That said, I am pretty that if the Fed did exactly as what I suggest above the US would very fast bee out of this crisis. The same goes for the ECB.

Update II: Marcus Nunes and Bill Woolsey also comment on Williamson. Nick Rowe comments on David Adolfatto’s anti-NGDP targeting post(s).


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