Return of the "real" economic anchors in monetary policy

As a recent Mint op-ed pointed out, the Friedmanite consensus on monetary policy may be another casualty of the global financial crisis. In his famous 1968 lecture at the American Economic Association, Milton Friedman had debunked the effectiveness of the Keynesian Phillips Curve relationship between inflation and unemployment. He questioned the belief that monetary policy could be used to stabilize the business cycle and lower unemployment arguing that it would only stoke inflation without any corresponding gains in reduction of unemployment rate. Agents (laborers bargaining for wage rise) would quickly factor in this expectation and thereby drive up inflationary pressures.

It also meant that governments and central banks could no longer target real variables to stabilize the output. Only a nominal anchor could achieve this purpose. Since then monetary policy has sought to  target a nominal anchor - initially money supply level, then exchange rate, and finally either price level or some measure of inflation. Inflation targeting was borne out of the last set of trends and have been underpinned by the New Keynesian theories about "sticky" prices. For nearly two decades, nominal inflation targeting has been the name of the game in monetary policy. 

However, in December, the FOMC announced a landmark decision to keep interest rates low till unemployment falls below 6.5%, so long as its inflation forecast remains below 2.5%. This effectively brings back "real" anchors back into monetary policy making. Fed Governor Ben Bernanke has argued that numerical thresholds for low rates would help “support household and business confidence and spending” and that this would make monetary policy “more transparent and predictable” to the public. 

But it is in Japan that nominal anchors are making the biggest splash. The new Shinzo Abe government looks set to make nominal anchors the basis of its macroeconomic policy making. After calling on the central bank to revise upwards its long-held inflation target to 2%, it has moved on to target other indicators. A recent Telegraph article wrote,

Mr Abe's Liberal Democrats have already lambasted the central bank, threatening a new bank law unless it adopts radical measures to pull Japan out of deflation – including a growth target of 3% for nominal GDP, implying massive monetary stimulus. He has set an implicit exchange range target of 90 yen to the dollar, instructing the Bank of Japan to drive down the yen with mass purchases of foreign bonds along lines pioneered by the Swiss.

The new Bank of England (BoE) Governor, Mark Carney recently suggested abandoning the nominal inflation targeting policy in favor of nominal GDP (NGDP) targeting. He said, "adopting a nominal GDP-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting". He argues that such a regime shift may be useful in times as now when the interest rate is touching zero-bound. Robin Harding wrote in the FT recently about NGDP,

The Fed’s new 6.5 per cent unemployment condition is a way to tell everybody that rates will stay low until the economy gets better. The nominal GDP target is a more drastic version of the same thing. In essence it combines growth and inflation into one number. Targeting this not only puts more weight on growth, it means promising to make up for low inflation now with more in the future – another way of saying the central bank will keep interest rates low.

In other words, inflation, nominal GDP, and even exchange rate have all become "real" economic anchors for a government looking to throw the kitchen sink in a desperate attempt to recover from its current deep slump. At a time when the economy is stuck in a protracted deflationary trap, interest rates are at zero bound, and excess capacity is widespread, nominal anchors may not be a bad strategy to shape expectations and get the economy's animal spirits active.

But in any case, it decisively marks the end of the Friedmanite consensus on nominal anchors in monetary policy making.