Tate Lacey of the Cato Institute has an interesting post discussing Jerome Powell’s recent Jackson Hole speech on monetary policy:
Powell constructed his remarks around a nautical metaphor of “shifting stars.” In macroeconomic equations a variable has a star superscript (*) on it to indicate it is a fundamental structural feature of the economy. In Powell’s words, these starred values in conventional economic models are the “normal, or “natural,” or “desired” values (e.g. u* for the natural rate of unemployment, r* for the neutral rate of interest, and π* for the optimal inflation rate). In these models the actual data are supposed to fluctuate around these stars. However, the models require estimates for many star values (the exception being desired inflation, which the Fed has chosen to be a 2% annual rate) because they cannot be directly observed, and therefore must be inferred.
Powell is worried that monetary policy needs to “steer” using various stars that are not clearly visible.
In addition:
Two years later, Powell said that traditional rules were backward looking, but that monetary policy needs to be forward looking and not overly reliant on past data. Upon becoming Fed Chair early this year, Powell made it a point to tell Congress he found monetary policy rules helpful—a sentiment he reiterated when testifying on the Hill last month.
The good news is that there is a monetary policy rule that is forward looking, not concerned with estimating the “stars,” and robust against an inflation fixation. I am referring to a nominal GDP level target, of course; a monetary policy rule that has been gaining advocates.
Lacey has identified a number of areas where Powell seems to (at least implicitly) understand the advantages of NGDP targeting.
1. One well-known advantage of NGDP targeting is that inflation targeting does not do well during periods of supply shocks. Inflation proponents try to remedy this problem by adding an estimate of “output gaps” to their policy approach, as in the famous Taylor Rule. But output gaps are notoriously difficult to estimate; indeed the Fed recently assumed that the natural rate of unemployment was well over 5%, a view that now seems incorrect. Under NGDP targeting, there is no need to estimate output gaps.
2. It is possible to construct a modified Taylor Rule for NGDP targeting, in which case you’d still need to estimate the natural rate of interest. However, Powell correctly notes that any Taylor Rule-type regime is excessively backwards looking, and policy is better off being forward looking. This leads to Lars Svensson’s call for “targeting the forecast”. If you target the market forecast of NGDP then there is no need to estimate the natural rate of interest. BTW, Alex Tabarrok recently discussed some very interesting research, which indirectly supports Robin Hanson’s claim that policymaking is most efficient when guided by prediction markets.
Of course NGDP targeting has many other advantages as well:
3. It does a better job stabilizing labor markets than does inflation targeting.
4. It does a better job stabilizing financial markets than does inflation targeting.
5. NGDP level targeting is a more rules based approach to policy than “let bygones be bygones” inflation targeting. Ironically, if the BOJ were to adopt a NGDP level target tomorrow (say along a 3% NGDP growth path), it would actually be easier to predict the Japanese price level in the year 2038 than it is under the current 2% inflation target. That’s because when the BOJ misses the 2% inflation target (as they do frequently) there is no “make up” to get back on track. Under 3% NGDP level targeting, I’d expect the Japanese price level to be about 40% higher in 2038. Right now I have no idea whether it will be 40% higher or 4% higher.
6. NGDP targeting is much easier to explain to the public. In 2010, Bernanke told the public he was trying to raise inflation to 2%, and 99% of Americans had no idea why he was trying to raise their cost of living. If he had instead said he was trying to raise the incomes of Americans by 5% to promote recovery, people would have understood the rationale for Fed policy. When people think of inflation, they think of the supply-side inflation that makes Americans poorer, not the demand-side inflation that the Fed is actually trying to influence.
Jerome Powell seems to have excellent instincts. My prediction is that the Fed will not immediately switch to NGDP targeting. Rather when we are about to enter the next recession, the Fed will use NGDPLT as a temporary expedient to create more stabilizing expectations, citing the research of Michael Woodford and others. When and if it is successful, they will quietly forget about the old inflation-targeting regime, and we’ll be in a new world of NGDP targeting. And then I can finally retire and read all those novels piling up on my shelf . . . Thank God!
HT: Alvin Rabushka
READER COMMENTS
Benjamin Cole
Sep 1 2018 at 7:25am
Well, perfectly fine post, and so was Tate Lacey’s.
I remain skeptical we can rely on an independent central bank, or at least the Fed, to apply enough stimulus during and after a recession, even with a tight 4% NGPLT.
Okay, suppose the US slips into a recession for a year, at zero real growth and flat prices. A no-growth, no-inflation picture for one year. That is not an exotic scenario, given 2008-9, or Japan.
Okay, at the start of year 2 the Fed has to try to not only make up the 4% lost ground, but should shoot for an 8% higher NDGPLT by end of year 2, and maybe 6-7% of that in inflation.
I doubt the Fed would have the stomach for 7% inflation in one year, to recover the 4% NGDPLT. And egads, if the US entered a two-year period of very sluggish growth and prices, I rest assured the Fed would give up ever getting back to NGDPLT.
Now, if the Fed reported to a Nixon, Reagan or Trump, we know they might actually hit the NGDPLT in one year.
The independence of the Fed has been sacralized. Of course, we see Turkey, or Zimbabwe. But we have also seen a ECB, Bank of Japan and Fed.
Interesting topic.
Rein
Sep 1 2018 at 11:23am
If the ECB wants to target NGDP, should it target NGDP for the whole eurozone or could it target each and every country separately?
Philo
Sep 1 2018 at 10:03pm
I don’t think the Fed could, for long, get away with “quietly forgetting the old inflation-targeting regime.” Not all Fed members would be on board, and the dissidents would force a public debate. And various journalists and politicians would raise a hue and cry about the Fed’s repeated failures to hit the (supposedly still operative) inflation target.
Scott Sumner
Sep 2 2018 at 6:20pm
Philo, Maybe I shouldn’t have used the term “quietly”. I meant that if the NGDP target worked well, then there would be a broad consensus for continuing with it. I expect the Fed would claim that their NGDP target was consistent with a long run inflation rate of 2%. Over time, people would pay less attention to inflation.
Thaomas
Sep 3 2018 at 11:19am
I think it is reasonable to suppose that NGDP targeting would do better than symmetric inflation targeting (price level trend targeting) plus employment targeting, but since the latter has never been tried in the US, (or at least not since 2008) we cannot really be sure. But if NGDP targeting is plagued by arbitrary constraints on the values of the instruments that can be used to carry it out, then it may be as problematic as existing policy.
Justin
Sep 5 2018 at 6:48pm
If and when they do switch to NGDPLT, the effect on asset prices could be huge, or at least you’ll want to be long the S&P 500 when it happens.
As you have said, Sumner, NGDPLT basically means the end of the business cycle, never again will nearly all firms have a massive drop in profits, all at the same time. If the probability of recession falls toward zero, stocks have to go up, potentially a lot. The risk of a recession every 4-6 years is surely baked into current stock prices. No more recessions means a lot more aggregate profits, extrapolated into the future and discounted.
Of course markets will suspect this could be the case, and perhaps they’ve already priced much of it in….no free lunch.
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