Jerome Powell replaced Janet Yellen as the new Chairman of the Federal Reserve.  This change will give the Fed a chance to reconsider how it conducts monetary policy.  There had been a consensus among macroeconomists since the 1980s, but like many things, it was shattered by the Great Recession. 

One alternative for the new Fed chair to consider is to target nominal GDP (Gross Domestic Product), or total spending in the economy.  The basic idea of nominal GDP targeting dates back to F.A. Hayek, but was popularized recently by Scott Sumner.  In the wake of the Great Recession, Sumner’s proposal jumpstarted a debate among economists and helped thrust him into national prominence.  In fact, Foreign Policy ranked him 15th on its list of 100 top global thinkers in 2012.

sumner pic
Sumner taught us a great way to get on the most influential people list:  
propose something most people don’t understand.

Current Fed Policy

The purpose of a central bank is to moderate what’s called the business cycle.  The business cycle is just changes in economic activity, or output of goods, over time.  In order to achieve stable output, Congress has given the Fed a dual mandate for low inflation and low unemployment.

Currently, the Fed tries to reach those goals through a policy called inflation targeting.  Inflation targeting is exactly what it sounds like, where the central bank targets an announced rate of inflation.  They do this because too much inflation is obviously a bad thing (remember the 1970s), but many also consider deflation just as bad.  Currently, 31 central banks around the world practice inflation targeting.

NGDP Targeting in a Nutshell

So, what exactly is this cool, new monetary policy?  Well, instead of targeting an inflation rate, the central bank targets the total spending in the economy.  Nominal GDP, a fancy word for total spending, is made up of inflation and real output.

According to the quantity theory of money, the money supply times the velocity of money equals the inflation rate times real output, or M*V = P*Y.  Because P*Y is the nominal GDP, a change in M and V will effect nominal GDP.  Because velocity—the rate at which my $10 bill goes from my pocket to someone else’s pocket—tends to be stable over time, the central bank uses the money supply to effect nominal GDP.  This relationship that underpins inflation targeting does not change under an NGDP targeting regime.

Rather than keeping inflation stable and allowing real output to vary, Sumner’s proposal calls for increasing nominal GDP at a constant rate. This is the growth path, where each year nominal GDP grows by that rate.  In this system, The Fed makes up for past mistakes by targeting the growth rate of total spending. Ignoring their previous mistakes, moving past it and attempting to hit their target the next period can lead to chronic overshooting or undershooting of their target.

always sunny gang
The Gang from It’s Always Sunny may want the Fed to “Move past it,” but Sumner argues that
making up for the past mistakes is important for monetary policy to be successful.

This’ll make it hit home:

Imagine you’re targeting 8 hours of sleep per night, but one night you come up short and only sleep 5 hours. If you plan your sleep schedule like the Fed plans policy, the next night you would still aim for just 8 hours. Say, you come up a little short again, and again, and again. All of a sudden, you end up sleeping the whole day due to your accumulation of hours missed. Under NGDP targeting, the next night, it would adjust your sleep time to 11 hours to make up for the hours lost the night before. (Wouldn’t that be nice?)

In practice, NGDP targeting can work with any number, but most supporters suggest a 5 percent rate.  Since World War II in the US, GDP growth has tended to be about 3 percent and inflation about 2 percent.  Assume nominal GDP starts at 100 to keep the math simple.  In year one the Fed misses their target, and for some reason, the nominal GDP grows at 4 percent to 104.  The next year the Fed will aim for a higher growth rate, to reach 110.25 and stay on trend.  This calls for 6 percent nominal GDP growth, and the Fed to increase the money supply to return to their path, like under inflation targeting.  The graph below shows the difference between making up for past mistakes and letting bygones be bygones.  This makes the Fed more transparent and accountable because observers can easily see nominal GDP and know instantly if the Fed will have to increase or decrease the money supply to reach their nominal GDP growth goal.


Under NGDP targeting, inflation can be variable in the short run, like in the example above.  Although inflation being unstable tends to worry economists (the failures of the 1970s are still burned in their minds, much like the Atlanta Falcons’ 28-3 Super bowl lead last year), as long as inflation over 5 to 10 years averages to 2 percent, any change will be expected and done to counteract small deviations from the nominal GDP trend.  Sumner argues that a stable nominal GDP itself prevents inflation expectations from unanchoring, or steadily increasing, because wages are tied closely to nominal GDP.

What Sets NGDP Apart Inflation Targeting?

One of the virtues of nominal GDP targeting is that it moderates the business cycle.  In practice, the Fed would be more expansionary in recessions and more contractionary during periods of high growth—essentially, preventing large changes in NGDP growth.

Another strength of NGDP targeting is it responds to changes in aggregate supply and aggregate demand appropriately. The causes behind changes in aggregate supply and demand are different, requiring different policy responses. In real time, though, they are impossible to tell apart. We’ll get into the details in another blog,  but because NGDP targeting does not require the Fed to know why the price level changed in order to respond appropriately, they respond better under an NGDP targeting regime.

Additionally, inflation targeting is problematic. Inflation can be difficult to measure. There is no reliable way to measure a change in quality.  My $300 flat screen TV is infinitely better than my grandparents 1970s console TV that cost them $300.  Also, it requires teams of people with clipboards to record prices of a predetermined basket of goods in stores.  If they cannot find the exact good, they must take what they think is a close approximate.

Another problem with inflation targeting became evident during the Great Recession.  When the Fed’s policy tool, the Federal Funds rate, reaches 0, they cannot get it any lower.  This is called a liquidity trap, where the Fed cannot lower the federal funds rate—the mother of all interest rates—through expanding the money supply.  Furthermore, Sumner argues that under NGDP targeting the Fed has more leeway, because they can effectively use other policy tools to increase inflation, whereas inflation targeting is limiting.

The Takeaway

So how big of a change is NGDP targeting from our current system?  Compared to free-banking, NGDP targeting is practically the status quo.  But for some Fed officials, a new policy regime seems like a radical departure and admittance of past failures.  The reality lies somewhere in between.  This new policy regime still involves a central bank engaging in active policy, but it is a much more stable than the current inflation targeting.

Federal Reserve Regional President Charles Evans has come out in favor of it, along with left-leaning economists Christina Romer and Paul Krugman.  They join economists on the right like Sumner, Hayek, and David Beckworth in the growing support for NGDP targeting.

Although it might seem like it’s above our paygrades to understand, these monetary policy regimes have some serious implications for the financial well-being of all of us. As the economic landscape continues to change with technological disruptions, the monetary policy that has been in place for the last three decades should be reevaluated to ensure it is the best possible.  It would probably be wise for the new Fed chair to at least consider NGDP targeting as a way to keep up with the ever-changing economy.

Updated and revised on February 20, 2018.


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