NGDP targeting, the hot new monetary craze that just might end the downturn
For quite some time now, Scott Sumner, an economist at Bentley University, has been arguing on his blog and elsewhere that the Federal Reserve should engage in a strategy called “NGDP targeting” to lift the economy out of its morass. All of the sudden, the idea is catching on. Paul Krugman has endorsed it. So has Financial Times columnist Clive Crook. Just recently, Goldman Sachs economists Jan Hatzius and Sven Jari Stehn released a research note making the case. So what’s this hot new monetary craze that might just end the downturn? Here’s a FAQ:
What is NGDP?
That one’s easy enough. Nominal Gross Domestic Product, or NGDP, is just the sum of all current dollar spending in the American economy. In other words, it’s a GDP figure that hasn’t been adjusted for inflation. Another way to look at it is that when nominal GDP grows, that means there’s been an increase in some combination of real economic growth and prices.
Okay, so what would NGDP targeting entail?
The Federal Reserve would pick a target for nominal GDP growth: let’s say it decides that, in an ideal world, NGDP would have been growing at 5 percent per year since 2007 (the last time we were at full employment). That’s the target, the place we should be at if all was well. Ben Bernanke would then announce that the central bank is going to do whatever it takes, including buying up assets and injecting money into the economy, until spending catches up to that target level. If all goes as hoped, this should help bring the economy back to full employment more quickly.
Why would this get the economy moving again?
As the Fed shifts expectations and/or begins injecting more money into the economy, a bunch of things would presumably occur. For one, long-term interest rates would go down and stay down, which should boost growth. Meanwhile, people would start to expect higher inflation and decide to spend and invest their money rather than holding it in cash. The key thing here, as advocates have noted, is that the Fed has to credibly commit to its goal, so that everyone expects national spending to rise and adjusts accordingly.
As the modeling exercise on the right from Goldman Sachs suggests, NGDP targeting should, in theory, get us back to full employment much quicker than doing nothing. While things like monetary stimulus can’t permanently raise real output — if it could, Zimbabwe would be lavishly rich — it can, say advocates, give a boost in the short term to a struggling economy that’s below its potential.
How is this different from what the Fed already does?
The Fed currently has a “dual mandate” to keep both inflation and unemployment low. In practice, however, the Fed tends to focus most of its attention on inflation. And that, some economists have argued, can create problems during a recovery. As spending starts increasing and people find jobs, inflation might tick up a bit. For instance, rents will start rising and nudge inflation up before housing constructing starts booming again. If the Fed is overly focused on inflation, then there’s the danger that it will throttle the recovery before it gets fully underway.
But with NGDP targeting, that’s less of a danger — the Fed will continue its focus on stimulus until the combination of real output and inflation reaches the stated growth target. It doesn’t matter what the mix actually is. This is one way for the Fed to focus on employment and inflation at the same time. Plus, at a time when Republicans are bashing Ben Bernanke for bringing about too much inflation, it’s more palatable for the Fed to say that it’s trying to raise overall spending rather than hiking up prices per se.
I don’t know, this still sounds like a recipe for runaway inflation.
Goldman Sachs addressed this in its research report. Let’s say the Fed chooses a 4.5 percent target for trend nominal GDP growth, because it thinks that, in the long run, the economy has the potential to grow at a real rate of 2.5 percent with 2 percent inflation over the long term. If the Fed’s wrong about the economy’s potential for growth, then it’s not a big deal. We get slightly higher inflation than expected, and the Fed has still firmly committed to letting up on faster growth once NGDP returns to its long-term trend. There’s less danger of the Fed keeping monetary policy loose for too long, as it did in the 1970s, and triggering runaway inflation.
Is there any chance this could fail?
Some economists, like Nobel laureate Peter Diamond, have argued that the Fed would have a hard time boosting inflation simply by announcing its determination to do so. Scott Sumner, for his part, has contended that there are no known examples of a central bank that has failed to inflate the economy when it has truly tried. (There’s some dispute over how successfully the Bank of Japan fared on this score in the 2000s.) Other economists, like Brad DeLong, have argued that it would be better to have both fiscal policy and monetary policy working in unison to raise overall spending in the economy, rather than relying solely on the Fed.
So what are the chances the Fed will do this?
That’s unclear. While the idea has been gathering momentum among economists and pundits, it’s worth noting that Fed chairman Ben Bernanke, for one, doesn’t seem to be a huge fan. Back in 1997, he and Frederic Mishkin argued that inflation targeting was a better approach than focusing on NGDP. But what about now? With the economy still gasping for air and the central bank so far unable to lift us out of the pits, it might be time to give unconventional approaches a second look. And PIMCO founder Bill Gross suggested that Bernanke’s most recent speech, emphasizing the importance of “communications,” might just be a subtle wink that the central banker is warming to NGDP mania.