Friday, January 25, 2013

The case for NGDP Targeting examined

As I blogged earlier, Inflation Targeting (IT), which underpinned the monetary policy consensus since the nineties, looks set to be another casualty of the global financial crisis. Nominal Gross Domestic Product (NGDP) targeting has become the most discussed alternative to IT.

As the name suggests, NGDP targeting seeks to fix a trend nominal GDP growth rate as the nominal anchor for setting interest rates and other monetary policy actions. This target is more effective than a pure inflation target at boosting output, especially when the economy is facing the zero-lower bound (ZLB) in interest rate. As Simon Wren-Lewis explains, an NGDP target works by relaxing monetary policy tomorrow in order to raise tomorrow's output and inflation. Assuming rational expectations, this response in turn immediately raises inflation today (since today's inflation depends on expected inflation tomorrow) and therefore reduces real interest rates today, which in turn raises output today and again inflation today. A simple inflation target cannot generate this effect on output today or tomorrow when the economy is facing ZLB.

Further, its supporters claim that by directly targeting the level of output growth, it avoids getting entangled with the intermediate objective of inflation, and focuses on the ultimate objective of stable economic growth. Central Bankers too are loath to give up their hard-won inflation fighting credibility which has helped firmly anchor inflation expectations for nearly two decades. Also, as Scott Sumner points out, it is politically easier to mobilize support since it re-frames the debate around output and avoids the contentious topic of inflation.

At a time when the developed economies are facing deflation and liquidity trap, a generous dose of inflation can be helpful in generating growth. But popular and ideological opposition to the idea of stoking inflation, borne out of a generation of inflation targeting, comes in the way of any attempt to promote growth, even by generating inflation consistent with the defined inflation target. Furthermore, monetary policy, in particular expansionary policy, has come to be intimately associated with inflation. NGDP targeting would replace inflation with output as the nominal anchor.

This distinction is a bit of sophistry, but enough to get political traction for expansionary monetary policy. Fundamentally, the effect of monetary and fiscal policies get distributed between output and price level changes - expansion causes both growth and inflation, while contraction lowers both. In other words, inflation and growth are two sides of the same monetary policy coin, though their relative magnitudes is determined by the nature of supply-side shocks and cannot be influenced directly through monetary policy.

So my concerns with the alleged superiority of NGDP over IT is as follows

1. It may be possible that in general NGDP cycles till now have been more closely correlated with asset inflation cycles than inflation cycles have been with asset prices. But there is limited theoretical basis for claiming that business cycles correlate strongly with asset price cycles, any more so than inflation cycles. Or do we, as before, avoid addressing asset prices, and deal with them through micro- and macro-prudential regulations?

2. Given that an NGDP anchor is the sum of potential output and optimal inflation target, any volatility in potential output is likely to introduce uncertainties into an NGDP targeting framework. If the potential output is itself not stable, then NGDP targeting becomes inconsistent with IT.

3. Further, a reliable assessment of output gap is critical to setting an NGDP anchor. In conditions of zero-lower bound, accuracy of the output gap is less important since even if the central bank over-estimates its magnitude, it can very easily raise rates to correct the situation. But if it under-estimates the gap, there is no possibility of going down in the opposite direction with interest rates. But this does not hold once we are faced with different economic conditions, like an overheating economy facing inflationary pressures.

4. This brings us to the most important flaw with NGDP targeting. A simple NGDP target would reveal little about the distribution of NGDP between real output and inflation. Consider two scenarios. In the first, high inflation caused by a supply-constrained and over-heating economy keeps real output growth low and NGDP below the target. In the second, deflation co-exists with demand-constrained economic conditions and keeps NGDP below the target. The policy prescriptions for the two conditions are different. Expansionary monetary policy would be inflationary in the former while growth stimulating in the second case.

The NGDP level per se would not provide enough information to guide us on the right policy. In fact, in the former case, we can reach the target NGDP level by monetary expansion which would only raise inflation further without creating jobs or boosting real output. But in a deflationary demand-constrained economy, monetary expansion is more likely to increase NGDP by boosting real output, by skirting around the issue of inflation. Since this is exactly the problem facing developed economies today, it is natural that any policy which is likely to promote recovery attract attention.

Fortunately, we now have real world examples of these two conditions being played out simultaneously. Even as many developed economies are struggling with deflationary recessions, India is grappling with a supply-constrained inflationary economic slowdown. In fact, just as NGDP targeting, by skirting around inflation, offers a politically feasible cover for monetary expansion in developed economies, inflation targeting, by focusing directly on persistent high inflation, provides a politically convenient excuse for the Reserve Bank of India (RBI) in not relaxing its monetary tightening.

The contrast between the two conditions is striking and representative of the difficulty of having a uniform policy suitable for all conditions. One practical approach would be to stick with IT, but use nominal GDP as an anchor to help restore growth in economies facing deflationary recessions and the  ZLB in interest rate. In this context, the strategy suggested by Jeffrey Frankel for central banks to shape expectations by introducing a long-run NGDP target and then dynamic short-run targets till growth is restored, without junking the long-run inflation target, looks appropriate.

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