Marcus Nunes directed me to a recent post where John Cochrane advocated price level targeting. I agree that price level targeting is superior to inflation targeting. He then responded to questions about nominal GDP level targeting:
Many comments here and on twitter ask about a nominal GDP target. I’m not a fan, for three reasons.
First, just what does the Fed do to hit a nominal GDP target? That objection is common to the price level target, but it’s an important point. Nominal GDP targeting advocates seem to think it solves the whole conundrum of just how do interest rates affect inflation. No, it’s just a different centering point of the Taylor rule. Raise interest rates if nominal GDP growth is high, lower it if low.
Second and more to the point, it assumes that “potential,” “supply” or “neutral” real GDP growth is constant or at least slow moving and known. If potential grows 2% real and you want 2% inflation, then the nominal GDP growth target is 4%, and the idea is that you let the economy take care of the split between real and nominal in the short run. I’m of the view that there is a lot more high frequency movement in “potential” than commonly thought, so even if the Fed achieved steady nominal GDP growth, there would be needless inflation volatility or needless deviation from neutral real growth. Real GDP grew 4% 1950-2000 and 2% since then. How long does it take the target to adapt to this sort of thing?
The idea is that the Fed isn’t smart enough to separate nominal GDP growth to real growth and inflation, so let that be endogenous. Of all the problems of monetary policy, this doesn’t seem like the worst to me.
Third, I like the clarity of a price level target. Even if you make it level, not growth, of nominal GDP, it’s muddy just how much inflation you should expect when borrowing money, financing a project, etc. Keep the units pure. Moreover, if you don’t like price index measurement issues, wait until you look in to GDP measurement issues. GDP is not consumer surplus.
None of those objections are persuasive.
1. The first point is correct, but (as Cochrane indicates) applies equally well to price level targeting (which he supports). I favor employing NGDP futures contracts to guide policy. I seem to recall that Cochrane once spoke positively of using CPI futures contracts in monetary policy.
2. The second complaint has been made many times by NGDP critics, and refuted many times by NGDP proponents. I’m not sure if Cochrane is familiar with that literature. NGDP targeting does not make any assumptions about potential GDP growing at a constant rate. Proponents see the variation in inflation due to RGDP fluctuations as a feature, not a bug in the NGDP regime. (One possible exception is changes due to population growth—arguably it would be better to target NGDP per capita, or per adult.)
In addition, at the level of individual prices there might actually be more volatility with a price level target than with a NGDP target. Consider an oil supply shock that raises oil prices by 50%. Assume oil is 2% of the CPI. Under a price level target you are forced to reduce non-oil prices by 1%. That’s thousands of needless price changes—menu costs. Under a NGDP target you would likely get a reduction in real GDP and a rise in the price level, leaving non-oil prices little changed. Many non-oil prices (like haircuts) are tied to nominal wages, which tend to be pretty stable under a NGDP targeting regime. When there’s an oil shock it’s easier to reduce real wages by allowing a slight rise in the price level, rather than squeeze nominal wages (and NGDP) lower at the cost of unemployment.
And this doesn’t even account for the issue of hedonics. The CPI doesn’t measure the change in the average price of products, it measures changes in quality-adjusted prices. If you have quality rising at 1%/year, you’d need the average nominal price of products to also rise at 1%/year to keep the measured CPI stable.
So price level targeting is not the policy that does the best job of reducing “menu costs”; indeed NGDP does better when there are supply shocks.
3. The third point is also incorrect—it’s easier to measure NGDP than inflation. To measure (overall) inflation accurately you need to measure both nominal and real GDP. Let’s say Tesla produces 2 million cars (final goods) at an average price of $60,000. Then using the final goods approach to NGDP you could say that Tesla contributes $120 billion to NGDP. But how does Tesla affect the price level? To determine its impact on inflation you must measure the quality change over time in a Tesla car. But what does “quality change” even mean?
The government says modern TVs are 99% cheaper than the TVs of 1960, mostly due to quality improvements. What does that mean? Does it mean I laugh 100 times as much watching Seinfeld on a modern TV as I would watching it on a 1960-era TV? I like modern TVs, and I agree they are vastly better—but 100 times better? By what metric? What does the term “better” even mean? Let’s be honest, quality estimates are pulled out of thin air by government bureaucrats that have
no objective method of measuring utility.
I have been promoting NGDP targeting for decades. I have yet to see any NGDP critic address the actual arguments being made by proponents of NGDP targeting. I am certainly open to counterarguments—indeed I suspect NGDP targeting is not the optimal policy. But it’s far better than what the Fed is currently doing. We had a massive undershoot of NGDP in 2008-09 and a massive overshoot in 2021-23. And we can all see what happened.
PS. Under the value added approach to GDP, you’d add Tesla’s value added to the value added of its suppliers.
PPS. If Cochrane insists on targeting a price index, I’d suggest he switch from price level targeting to nominal wage level targeting. That’s an idea I could support.
READER COMMENTS
Kurt Schuler
Jul 28 2023 at 3:38pm
Given the difficulty that the Fed and other central banks have had in hitting their inflation targets, what makes you confident that they would do any better with NGDP targets? Or would, say, a 5 percentage point error matter less with NGDP targets than with inflation targets?
Scott Sumner
Jul 28 2023 at 4:39pm
The key distinction here is not between NGDP and inflation, it’s between level targeting and growth rate targeting. It’s much easier to hit a level target (either the price level or NGDP level) than a growth rate target.
Thomas L Hutcheson
Jul 28 2023 at 6:17pm
Is it? The future PLT or IT both imply a series of intermediate PL’s. The future NGDPLT implies a series of intermediate NGDP’s. Every month would show the Fed either having hit or no hit the intermediate target level for that month. Now of course that would not happen with a target for an NGDP futures market that the Fed could just buy or sell into to keep it arbitrarily close to its target. But then the same could be done for a PL futures target.
Scott Sumner
Jul 29 2023 at 12:30pm
Market interest rates adjust in such a way that it’s easier to hit a level target.
Thomas L Hutcheson
Jul 29 2023 at 2:07pm
???
But whether it is a rate target or a level target, it is a level number that is observed each month. The rate target implies that the level that will be observed at time Tn will be T0*(1+r*)^n. if r* is the target rate. Either way what has to be observed is exactly the same and the Fed either hits it or it does not. This is true even if Cochrane means that Tn* = T0 so that r =-1 +(Tn*/To)
George Selgin
Jul 29 2023 at 12:26pm
Kurt,
MV=Py.
P stabilization calls for the CB to stabilize P = (MV/y). That is, there are two variables changes in which it must anticipate and respond to with M changes.
Py nominal income) stabilization calls for the CB to stabilize P = MV.That is, it must anticipate and respond to changes in V, but not changes in y, which it ignores.
Therefore, Py stabilization is at least easier, even if it isn’t easy.
George
robc
Jul 28 2023 at 4:38pm
On point #3, wouldnt something like a constant change in monetary base (or monetary base per capita or monetary base per adult) be much easier to calculate than either GDP or inflation?
Scott Sumner
Jul 28 2023 at 4:40pm
Yes, much easier to calculate, but it would be a very bad idea. Base velocity is quite unstable.
Kevin Erdmann
Jul 28 2023 at 4:46pm
Price level targeting is much more hawkish than Volcker was, and surely would have been much worse. Is there something I’m missing?
marcus nunes
Jul 28 2023 at 5:32pm
Kevin, I believe PLT is even worse than IT. A significant negative supply shock would spell the death of the target for, otherwise a potentially big depression would likely ensue.
Thomas L Hutcheson
Jul 28 2023 at 6:07pm
What’s missing is the targeted intermediate PLs between any “now” and the future PLT. It looks exactly like IT, but less well defined and without the flexibility of FAIT.
Scott Sumner
Jul 28 2023 at 6:17pm
I wouldn’t say it’s more hawkish. A PLT that allows 2% annual inflation on average is equally hawkish to a 2% inflation target.
Kevin erdmann
Jul 28 2023 at 7:34pm
Scott,
I’m thinking specifically of a counterfactual where Volcker commits to PLT.
It seems reasonable and even optimal to reverse a deflation and get back to trend, but it seems that the other direction is very problematic.
Level targeting would be fine in a context where there was sufficient control over the target, but where there isn’t, it seems like committing to a return to level targets after an inflationary surprise has lots of potential downsides.
Scott Sumner
Jul 29 2023 at 12:32pm
I’m not sure what you are suggesting. If a new level target regime were adopted, it would presumably start from the existing position. If we’d had level targeting back in 1965, then the Great Inflation never would have happened and there’d be nothing for Volcker to offset.
Thomas L Hutcheson
Jul 28 2023 at 6:01pm
But how does Cochrane set the optimal rate of increase in the price level to get to the future price level target? Surely he cannot mean a fixed price level. And having set the future level target, what does the Fed do about deviations from the trajectory getting to it?I do think he has a point about observations of price levels being easier to observe than observations of NGDP levels, though creation of a NGDP futures market that the Fed could intervene in would off load that problem to market participants.
Matthias
Jul 30 2023 at 7:06am
Why could he not mean a constant level?
George Selgin even suggests that deflation might be good. (He basically argues in favour of a constant ngdp level target, and a growing real GDP would then lead to deflation.)
The book in question is called Less Than Zero.
steve
Jul 28 2023 at 10:24pm
Clarification. If wages are increasing ahead of inflation but remain behind pre-pandemic levels would you still council aggressive action?
Steve
Scott Sumner
Jul 29 2023 at 12:34pm
I’m not sure what you mean by “aggressive action”. I’d simply aim for 3% annual wage growth. I’d ignore price inflation.
steve
Jul 29 2023 at 2:58pm
So it sounds like you would not be concerned or would not address incomes being behind what they were 3 years ago. Not good for worker purchasing power.
Steve
Jim Glass
Jul 29 2023 at 9:07pm
“I’d simply aim for 3% annual wage growth. I’d ignore price inflation.”
So it sounds like you would not be concerned or would not address incomes being behind what they were 3 years ago. Not good for worker purchasing power.
Worker purchasing power tracks inflation very closely. After all, every dollar of increased cost to a consumer is a dollar of increased income to a provider – who in turn consumes from other providers, etc.
Data for the last five years, from FRED, Q1 to Q1, 2018 to 2023…
CPI : +20.88%; Employee compensation: +20.83%
Not much “being behind” in that.
Matthias
Jul 30 2023 at 7:08am
The best monetary policy can do for ‘worker purchasing power’ is to stay out of the way and not make things worse.
Scott Sumner
Jul 30 2023 at 1:48pm
Steve, You are mixing up real and nominal variables. Monetary policy does not determine the long run path of real wages.
To the extent that monetary policy affects real wages in the short run, easier money lowers real wages. Wages are stickier than prices.
Jim Glass
Jul 28 2023 at 10:42pm
“Consider an oil supply shock that raises oil prices by 50%. Assume oil is 2% of the CPI. Under a price level target you are forced to reduce non-oil prices by 1%. That’s thousands of needless price changes”
Isn’t this like what happened in 2008? Through August the price of oil doubled year-on-year. Is this price increase going to cause inflation? Or is the real impact of it going to be recessionary and cause deflation? If you are the Fed, what to do?
Hmm … The Fed in September announces that due to “risk of inflation” it will keep interest rates steady. As deflation had already started in July, this amounts to a real interest rate increase just as a recession starts. What one might expect to follow, follows. (Reminds me, IIRC, of the Fed raising rates by 2 point in 1931.)
~~~~~
As an aside, I’m very impressed by how our social memory has totally forgotten the populist crisis that howled as oil went from $49 in 2007 to $128 in Jul7 2008, making what happened last year look trivial. Oil was going to $500! $1,000! The world was running out of oil!! (Today’s green dream.) Congressional hearings. Investigations into hoarders profiteering to crush the economy …. today, all memory gone. Now it is ‘Bankers, bankers, evil bankers, they caused the Great Recession.’ Which is very peculiar as, since the deflation preceded the banking crisis, it requires causation that works backwards through time. Which seems to bother nobody. 🙂
Scott Sumner
Jul 29 2023 at 12:35pm
Yes, 2008 is a good example of that problem.
Matthias
Jul 30 2023 at 7:10am
I agree with your point in general.
However: causation working backwards in time is perfectly normal in economics. Economic actors anticipate events all the time.
That’s the only reason startups get funded, and money gets invested in companies at all.
spencer
Jul 29 2023 at 9:27am
Make-up polices unnecessarily aggravate equilibrium and potentiality trends. Policy corrections must be immediate.
Banks don’t LEND deposits. Deposits are the result of lending/investing. Bank credit must be regulated by using reserve requirements and reserve ratios. Requirements must be uniformly applied against all deposits. Hasn’t anyone ever studied reserves?
Powell eliminated reserve requirements because he thinks banks are intermediaries (i.e., to appease the ABA).
Arqiduka
Jul 30 2023 at 5:32am
Happy to be corrected if wrong, but the deflator approach to inflation isn’t what Central Banks actually track. Instead, they use a basket of goods approach which measurement can be near instantaneous.
In practice, a coarse price level target is easier to implement then an NGDP target. Not a slam dunk, but there’s that.
spencer
Jul 30 2023 at 7:05am
Gross Domestic Product (A191RP1Q027SBEA) @ 4.7% is acceptable. But the 3rd qtr. looks weak.
Matthias
Jul 30 2023 at 7:13am
If you set up the details just right, nominal wage level targeting is essential equivalent to nominal aggregate wage level targeting anyway.
Details like whether you track hourly wages or yearly wages. Or whether you count the unemployed as having a wage of zero for the purposes of figuring out the average wage. Etc.
spencer
Jul 30 2023 at 7:36am
Vt is still accelerating through July.
Large Time Deposits, All Commercial Banks (LTDACBM027NBOG) | FRED | St. Louis Fed (stlouisfed.org)
//
As Dr. Philip George says: “The velocity of money is a function of interest rates”
//
As Dr. Philip George puts it: “Changes in velocity have nothing to do with the speed at which money moves from hand to hand but are entirely the result of movements between demand deposits and other kinds of deposits.”
Michael Sandifer
Jul 31 2023 at 2:17am
My confidence continues to grow in the idea that broad stock indexes can be used to level target NGDP. There’s more to add, but I just put up a post with a simple explicit model relating interest rates, earnings, and economic growth to stock prices. It explicitly rejects the Gordon growth model with some reasons outlined.
It also expands on a point I’ve been making for years, and that the author of this post made for years prior to that, which is that low real interest rates do not cause higher stock prices. Indeed, I go further (I think Scott has too.) and add that low interest rates don’t affect stock multiples at all, but the common variable affecting both is NGDP growth expectations. And, higher multiples, in the context of NGDP growth that has fallen below expectations, reflects catch up growth expectations, when earnings are relatively weak. Those weak earnings reflect low NGDP growth. The higher multiples are more than offset by the drop in earnings, and earnings growth will relatively lag in weak economies.
I point to the example of Japan, where stock prices collapsed circa 1990, as real and nominal interest rates declined. This is because NGDP declined and stayed depressed.
Additionally, I can point out here that the gap in terms of a factor (~1.5%) between the mean interest rate and the mean NGDP growth rate in the US, from the beginning of 2007 until the beginning of 2019, for example, is the same as that between mean NGDP growth and S&P 500 appreciation. I don’t think this is an coincidence, and it reflects a shortfall in NGDP growth in the lower just over 1% range, with most of that being real. That means real and nominal growth would have slowed after 2007 even sans tight money, but less than what actually occurred.
Again, in the longer-run, the mean S&P 500 earnings yield and the mean US NGDP growth rate are equal, and I interpret divergences as examples of macro disequilibrium.
spencer
Jul 31 2023 at 10:11am
How do N-gDp growth expectations deal with expanding and contracting P/E ratios?
S&P 500 PE Ratio – 90 Year Historical Chart | MacroTrends
Michael Sandifer
Jul 31 2023 at 5:31pm
Spencer,
Assuming that question was intended for me, divergences between the S&P 500 earnings yield and NGDP growth indicate macro disequilibrium. Since the economy is just about always out of equilibrium to some degree, one should expect fluctuating P/E ratios.
More specifically, to use a specific example, if NGDP growth expectations fall by 50%, the multiple doubles, but earnings fall by 75% ((change in expected NGDP growth)^2), leading to a stock price decline of 50%. This is roughly what happened during the Great Recession, for example. This same relationship holds for the pandemic recession.
That is,
P = e(change in g)^2/g + (change in g),
where “P” is price( S&P 500), “e” is earnings, and “g” is expected NGDP growth.
Michael Sandifer
Jul 31 2023 at 5:34pm
I neglected to add some brackets.
P = e(change in g)^2/[g + (change in g)]
Michael Sandifer
Aug 1 2023 at 1:55am
I also neglected the “1 + …”. P = e(1 + change in g)^2/[g + (change in g)]
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