Alternative monetary policy targets continue to gain advocates. While Chair Powell was waiting to take over leadership at the Fed, internal support for rethinking the current inflation rate target was building. And while there are various possibilities to consider — such as raising the inflation rate target, turning the inflation target into an inflation rate range, or adopting price level targeting — there are reasons to believe that the Fed may end up choosing a nominal GDP target.
Powell testified before Congress for the first time last week and affirmed the Fed's commitment to the current framework, including the symmetric 2% inflation target. However, he also went out of his way to state that the FOMC "routinely consults" monetary policy rules in their analysis and that he finds these rules "helpful." According to David Beckworth of the Mercatus Center, this is the strongest endorsement of rules yet from a Fed Chair. If Powell is open to an expanded role for monetary policy rules, it is reasonable to think he may be open to a superior monetary policy target as well.
A New Target
Shortly after her successor testified on Capitol Hill, Janet Yellen made her first public appearance as former Fed Chair in a Brookings Institution interview — with her predecessor Ben Bernanke — about her time leading the Fed and career as an economist. When asked about potential alternatives to the Fed's current framework, Yellen essentially dismissed raising the inflation rate target, something Bernanke has also done, on both political and economic grounds. On the other hand, Yellen volunteered nominal GDP targeting as an alternative, claiming it has "interesting advantages."
Some of Yellen's former colleagues within the Federal Reserve System are also open to changing the Fed's target. In her brief remarks delivered at the University of Chicago's Annual Monetary Policy Forum two weeks ago, Loretta Mester, President of the Cleveland Fed, supported reexamining the Fed's inflation rate target — but added that any change would need to clear a very high bar.
However, Mester also suggested that nominal GDP level targeting and price level targeting were quite similar frameworks. She worried that under either regime a central bank might tighten policy after a negative supply shock raised prices, even if the economy was suffering from weak demand. Such tightening would be undesirable, of course. But in fact it is a risk only under price level targeting. With a nominal GDP target, the central bank would stabilize overall spending. That means the central bank would allow a decline in supply to raise prices without overtightening monetary policy.
Mester treating a price level target and a nominal GDP level target as almost one and the same was curious, because this was not the first time she had discussed alternative frameworks this year. Mester also gave a similar talk at the AEA annual meeting in January. In that discussion, Mester stressed that nominal GDP targeting was superior to other targets when the economy was hit with supply shocks. Mester expressed concern with measurement issues and the lack of central bank experience with nominal GDP level targeting, but spoke positively about it overall.
Mester's was not the only prominent voice discussing nominal GDP targeting at the AEA annual meeting. The most notable discussion occurred during a panel titled Monetary Policy in 2018 and Beyond, when former Council of Economic Advisers Chair Christy Romer endorsed the idea, citing research done with her economist husband, David Romer.
During her presentation, Romer first asked: "Why should the Fed be thinking about a new target now?" She offered two answers to this question. First, she discussed the poor performance of monetary policy over the last ten years, including its failure to allow for a more robust recovery. Second, she rightly identified growing congressional pressure for more accountability at the Fed via a rules-based monetary policy — something that nominal GDP level targeting moves toward.
The Right Target
Why is nominal GDP, particularly the level, the right target? Romer began her answer with what may be called the "bygones" argument. Under inflation rate targeting, whenever the central bank misses its target that miss is a permanent mistake. That's because the central bank will seek to restore the rate of inflation, rather than the price level. Policymakers would essentially let bygones be bygones, hence the name.
But policy misses distort the ability of economic actors to make their decisions, by either eroding the value of money with easy policy or acting as a contractionary force on economic activity with overly tight policy. And when a central bank is targeting a rate, policy misses are essentially written off rather than corrected — unlike under level targeting.
Under a nominal GDP level target, on the other hand, if the Fed was undershooting (or overshooting) the target, it would automatically make up for errant past performance by returning to the longer trend. If the Fed was generating too much inflation, which would be identified as excess spending, the Fed would know to tighten policy until nominal GDP was back on its trend path. Such a feature essentially eliminates the bygones problem of permanent errors and improves macroeconomic stability.
A nominal GDP level target is also superior to an inflation rate target because of desirable expectations effects, according to Romer. Keeping nominal GDP on a level path would firmly anchor expectations. Inflation expectations have been well anchored for some time, but due to the Fed's persistent undershooting of the inflation rate target there is at least some chance those expectations could become unanchored.
Strengthening these expectations in turn leads to yet another benefit: increased accountability for Fed policy. With a nominal GDP level target there would be no ambiguity as to whether or not the Fed was successfully implementing policy. A successful policy would return nominal GDP to its trend line. Whereas now the Fed can continually claim it's approaching its long-run inflation target, neither the public nor policymakers would tolerate that wait-and-see approach under a nominal GDP level targeting regime because it would be so clear when policy was failing. Romer provided a table showing that a nominal GDP level targeting would have improved the Fed's performance over the last five policy cycles.
Romer concluded her remarks with optimism for a new target: now is the right time for the Fed to be rethinking its operating framework and a nominal GDP level target can work in practice. She pledged to continue this line of research.
A Robust Target
The day after the AEA meeting, the Brookings Institution hosted an event asking if now is the right time to rethink the 2% inflation target, which was adopted by the Fed in January 2012.
During the panel discussing different options for the Fed's target, Jeff Frankel argued that targeting nominal GDP is superior to targeting the inflation rate. In addition to emphasizing some of the arguments that Romer made, Frankel added two key points. (His slides can be found here.)
First, a nominal GDP target is the target most consistent with how the Fed ought to be making policy decisions. It is, of course, important for a central bank not to overly focus on short term data. However, it's equally important that the Fed not run an open ended policy that is always working towards, but never actually achieving, its goal. The Fed ought to be setting policy over the medium term, typically 1-2 years. Under inflation rate targeting, the Fed has been missing its target, in one direction, for years. A nominal GDP target would give the Fed a nominal variable that they could keep on a stable trend.
Second, and most importantly, a nominal GDP target is the most robust target available to policymakers with respect to shocks, particularly aggregate supply shocks. Under an inflation rate target a central bank needs to differentiate between supply and demand shocks. It is supposed to "look through" the supply shocks and offset the demand shocks. This means the Fed shouldn't raise rates because an oil shortage raises the price of gas and they shouldn't cut rates if a productivity boom make consumer goods available at lower prices. With a nominal GDP target the central bank does not need to differentiate between supply and demand shocks in real time. Rather, the Fed would monitor the overall level of spending in the economy and adjust the stance of monetary policy so that it was forecasting hitting its nominal GDP target over the medium term.
Frankel's presentation would have been stronger had he specified that targeting the level of nominal GDP was the most desirable strategy for the Fed to adopt. His remarks could be read that he's ambivalent between targeting the growth rate or the level of nominal GDP. But, of course, targeting the rate has the same "bygones" problem that Romer discussed when criticizing the inflation rate target.
While Frankel was scheduled to be the nominal GDP advocate at the event, an unexpected boost for nominal GDP level targeting came from Larry Summers. During the Q&A following his speech, which explained why the 2% inflation target is no longer appropriate, he was pressed on which alternative framework he would choose. He opted for a nominal GDP level target of 5-6%. While it's easy to quibble with how Summers arrived at this decision — he sees it as the surest way to get higher nominal interest rates — to have an economist of his stature advocating for a nominal GDP level target is all to the good.
This is not the first year that prominent economists have announced support for targeting nominal GDP. For example, in late 2011 Paul Krugman expressed support when Christy Romer was urging Bernanke to channel his inner Paul Volcker and adopt nominal GDP level targeting. Therefore it was a bit odd when, as the keynote speaker at University of Chicago's Annual Monetary Policy Forum, Krugman said that inflation rate targeting was insufficient, but that he did not have a replacement. Stranger still, given that Krugman was an advocate of nominal GDP targeting in aftermath of the Financial Crisis.
Obviously, the year is young. But if these first two months are any indicator, 2018 may see a breakthrough for nominal GDP level targeting. As Scott Sumner likes to say, the Fed often follows the economics profession. The Fed is already discussing research on alternative frameworks, including level targeting. If more economists endorse a nominal GDP level target, then the Fed may move from researching it to adopting it. This would be welcome news.