Changing target: Should the Fed target nominal GDP?

[dkf]

OVER a decade ago a frustrated Ben Bernanke, then an economics professor at Princeton University, called for Japanese central bankers to show some “Rooseveltian resolve” and to act more boldly as total nominal demand in Japan was “growing too slowly for the patient’s health”. He might have been delivering a stern advance warning to himself in his current job as head of America’s Federal Reserve. Judged by its record on inflation, the usual yardstick, the Fed is performing fairly well. But judged by the criterion Mr Bernanke had used for the Japanese economy in the late 1990s, something has gone badly wrong. America’s nominal gross domestic product—GDP before adjusting for inflation—collapsed during the recession and is now nearly 12% below where it would be if its pre-recession trend had continued.

The slump in nominal GDP has had pernicious effects. It has raised both public and private debt burdens, since the ability of households, firms and governments to service their debt depends upon their nominal incomes and revenues. The gap between the performance of inflation and that of nominal GDP is so big that some economists, such as Scott Sumner of Bentley University, are dusting off an old idea. They are calling for central bankers to switch targets. Rather than directing monetary policy to hit inflation targets (as they have done for the past 20 years) central bankers should take aim at nominal GDP (or NGDP).

To adopt NGDP targeting, central bankers would set or be given a goal for how fast it should grow, most likely an annual rate of 4-5%. That corresponds in most rich countries to inflation around the 2% target now generally preferred and long-term potential growth of 2-3%. Monetary policy would then react as it does now, easing when NGDP growth was expected to be too sluggish and tightening when it was expected to be too exuberant. If nominal GDP fell below the target growth rate in one year, central banks would seek to make up for that in subsequent years—in effect, following a path for overall nominal spending. The division between inflation and real growth would vary from year to year.

A central bank’s tools would be the same: adjusting short-term interest rates in normal times and reaching for unconventional implements such as quantitative easing—buying assets by creating money—when interest rates are, as now, close to zero. The difference lies in what signals the new target would send. At present a central bank targeting nominal GDP would be loosening policy much more aggressively. Mr Sumner reckons that the commitment to hit an NGDP target would itself boost the economy; but if it didn’t, the Fed would presumably have to do even more quantitative easing until the target was hit.

http://www.economist.com/node/21526886

[MannyGoldstein]

1. This is a great idea. nt

[roamer65]

2. I smell 20-30% inflation in our near future.