Jeff Frankel restates his support for NGDP targeting
It is no secret that I have been fascinated by some of Havard professor Jeff Frankel's ideas especially his idea for Emerging Markets commodity exporters to peg the currency to the price of their main export (PEP). I have written numerous posts on this (see below) However, Frankel is also a long-time supporter of NGDP target and now he has restated is his views on NGDP targeting. Here is Jeff:
"In my preceding blogpost, I argued that the developments of the last five years have sharply pointed up the limitations of Inflation Targeting (IT), much as the currency crises of the 1990s dramatized the vulnerability of exchange rate targeting and the velocity shocks of the 1980s killed money supply targeting. But if IT is dead, what is to take its place as an intermediate target that central banks can use to anchor expectations? The leading candidate to take the position of preferred nominal anchor is probably Nominal GDP Targeting. It has gained popularity rather suddenly, over the last year. But the idea is not new. It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to shifts in money demand. Under certain conditions, it dominates not only a money target (due to velocity shocks) but also an exchange rate target (if exchange rate shocks are large) and a price level target (if supply shocks are large). First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean(1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein & Jim Stock (1994), Bob Hall & Greg Mankiw (1994), Ben McCallum (1987, 1999), and others. Nominal GDP targeting was not adopted by any country in the 1980s. Amazingly, the founders of the European Central Bank in the 1990s never even considered it on their list of possible anchors for euro monetary policy. (They ended up with a “two pillar approach,” of which one pillar was supposedly the money supply.)"So far so good...and here is something, which will make all of us blogging Market Monetarists happy:
"But now nominal GDP targeting is back, thanks to enthusiastic blogging by ScottSumner (at Money Illusion), LarsChristensen (at Market Monetarist), David Beckworth (at Macromarket Musings),Marcus Nunes (at Historinhas) and others. Indeed, the Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere."This is a great endorsement of the Market Monetarist "movement" and it is certainly good news that Jeff so clearly recognize the work of the blogging Market Monetarists. Anyway back to the important points Jeff are making.
"Fans of nominal GDP targeting point out that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand, which is really all that can be asked of monetary policy. An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway. In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target). But why has it suddenly gained popularity at this point in history, after two decades of living in obscurity? Nominal GDP targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world: Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture."Exactly! The great advantage of NGDP level targeting compared to other monetary policy rules is that it handles both velocity shocks and supply shocks. No other rules (other than maybe Jeff's own PEP) does that. Furthermore, I would add something, which is tremendously important to me and that is that unlike any other monetary policy rule NGDP level targeting does not distort relative prices. NGDP level targeting as such ensures the optimal and unhampered working of a free market economy. Back to Jeff:
"Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential. It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: 4 or 5 per cent. (This is what Krugman and Ben Bernanke advised the Bank of Japan to do in the 1990s, to get out of its deflationary trap.) But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2 per cent which they fought so long and hard to achieve in the 1980s and 1990s. Of course one could declare that the shift from a 2 % target to 4 % would be temporary. But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number. An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year - which for a country teetering on the fence between recovery and recession would in effect supply as much monetary ease as a 4% inflation target - and yet one would not be giving up the hard-won emphasis on 2% inflation as the long-run anchor."
I completely agree. I have always found the idea of temporary changing the inflation target to be very odd. The problem is not whether to target 2,3 or 4% inflation. The problem is the inflation targeting itself. Inflation targeting tends to create bubbles when the economy is hit by positive supply shocks. It does not fully response to negative velocity shocks and it leads to excessive tightening of monetary policy when the economy is hit by negative supply shocks (just have look at the ECB's conduct of monetary policy!)
Market Monetarists advocate a clear rule based monetary policy exactly because we think that expectations is tremendously important in the monetary transmission mechanism. A temporary change in the inflation target would completely undermining the effectiveness of the monetary transmission mechanism and we would still be left with a bad monetary policy rule.
Let me give the final word to Jeff:
Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.
Some of my earlier posts on Jeff's ideas:Next stop Moscow International monetary disorder – how policy mistakes turned the crisis into a global crisis Fear-of-floating, misallocation and the law of comparative advantages Exchange rates are not truly floating when we target inflation “The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression PEP, NGDPLT and (how to avoid) Russian monetary policy failure Should small open economies peg the currency to export prices? Scott Sumner also comments on Jeff's blogpost.