Some doubts about NGDP targets

Britmouse wants the UK to adopt a nominal GDP target. There's nothing cranky, partisan or new about this; Sam Brittan advocated it in the 80s and the IPPR in the 90s. However, I'm not sure it would make much difference. Here are some pros and cons.

Pro: It would permit a looser monetary policy than inflation targeting. For example, a 5% NGDP target would mean targeting 4% inflation if real GDP looks like growing just 1%.

C0n: The very fact that inflation has consistently overshot its target suggests that the Bank of England has been running a looser policy anyway. It could be a closet NGDP targeter.

Pro: The 2009 recession was an NGDP recession; it fell by 4.8% between its peak and trough. An NGDP target would thus have prevented the recession.

Con: No. The problem in 2009 wasn't so much that policy was too tight but that the Bank's GDP forecasts were too optimistic. For example, in August 2008 it was forecasting that real GDP would grow 0.6% in the following four quarters, but in fact it dropped 3.7%. Had the Bank's forecasts been more accurate, it would have run a looser policy even with an inflation target. An NGDP target would not solve the problem that forecasts are inaccurate.

Pro: An NGDP target would raise inflation expectations and so encourage people to spend rather than to hoard cash paying strongly negative real interest rates.

Con: But the public's inflation expectations have been above 2% for a long time, without unleashing great spending growth. There are many other things restraining spending that are more important than expected real interest rates.

In fact, there's a danger that higher inflation expectations might constrain growth, if they cause gilt yields and borrowing costs to rise.

Pro: Our economic problem is a nominal one and therefore the solution is nominal.

Con: Really? Are real factors such as a lack of investment opportunities, falling productivity growth and a mismatch between supply and demand really unimportant? And to the extent that our problem is a nominal one, it lies in the fact that banks are not creating money by lending. As Adam Posen said, fixing the banks is therefore a priority - more, I'd add, than tweaking monetary policy targets.

Now, I do not say this to suggest that an NGDP target would be a bad thing. Instead, I regard as a member of that very large set of policies that might not make very much difference.

Comments

[Luis Enrique]

how can you simultaneously believe that banks need "fixing" because they are not lending, and that there is a dearth of worthwhile investment opportunities?

[Britmouse]

1. The BoE allowed only 3% NGDP growth in 2011, so if they were targeting a 5% growth rate they failed miserably; they are about 11% off the pre-crisis 5.3% trend line. I doubt the GDP figures are 2% out, let alone 11%.

2. Agree somewhat that using BoE forecasts might not help short term, but level targeting means we can catch up when they screw up. Using market forecasts a la Scott Sumner is better. Markets accurately predicted doom post-Lehman (e.g. inflation expectations crashed and burned), the Bank did not. Market inflation expectations have stayed below long-term trends ever since.

3/4. These are basically the same thing, policy defeatism: more demand will only be inflationary. If you take nominal GDP at Basic Prices to ignore distortions from VAT, output has tracked nominal demand up and down very closely. Is that just a fluke? Why should it be the presumption of policy makers the rise in UK under/unemployment is structural, absent any evidence?

[chris]

@ Luis - you've been reading too much representative agent economics. There's heterogeneity among firms. Some lack investment opps, some (fewer and smaller, I suspect but still important) finance.
@ Britmouse - everyone forecast doom post-Lehman, but by then the recession was well under way, and it was too late for looser policy to prevent it. And anyway, the Bank did fairly aggressively in late 08-09. I don't recall NGDP targeters calling vocally for looser policy in 08.

[Luis Enrique]

maybe ... but if you want to say that across the distribution of heterogeneous firms there is on average a dearth of investment opportunities, and across the mass of heterogeneous firms there is on average a lack of credit for investment, that still looks hard to reconcile. You can say these problems exist in different parts of the distribution, but then you need a story about why investment opportunities are presenting themselves to firms that also happen to lack credit, whilst well-funded firms happen to lack investment opportunities. You mention firm size, why should we think only small firms have investment opportunities?

[Britmouse]

"everyone forecast doom"

Everybody in the markets did, and they right. It took the Bank six months to get Bank Rate down to 0.5%.

http://uneconomical.wordpress.com/2012/02/10/apocalypse-then/

[Keith]

It would be nice if Chris had some ideas about reviving the economy of his own which he could share with us.

[chris]

@ Keith. I think fiscal expansion would do some good, especially if financed by QE. However, I'm not at all sure if any feasible macro policy can create the 4-5m jobs required to get us to full employment.
For this reason, I support more help for the unemployed, both through higher benefits (a citizens income?) and from active labour market policies that genuinely work and do not stigmatize the jobless.

[Andrew]

The above seems fairly sensible. Of course macro policy can't create 4-5m jobs. If created, there would be no conceivable way of making sure they aligned with useful (in-demand) activities) once the stimulus ended.

[asdasdasd]

"The very fact that inflation has consistently overshot its target suggests that the Bank of England has been running a looser policy anyway. It could be a closet NGDP targeter."

But being a closet inflation targeter results in the worst of all worlds. The BoE aims to hit its headline CPI target, everyone expects low inflation and low demand, but then monetary policy is more expansionary than expected so we get high inflation and lower output.

RPI breakevens (3.75 yr) are currently 2.5%, market expectations of inflation are consistent with the BoE undershooting its headline CPI target.

"The problem in 2009 wasn't so much that policy was too tight but that the Bank's GDP forecasts were too optimistic."

? monetary policy was clearly too tight in 2008-2010, look at the real-time inflation breakevens and the path of nominal GDP, it crashed. With perfect foresight the BoE would have responded much more aggressively.

Now if the forecasts are inaccurate, why is the BoE still using them to guide policy? Real-time inflation break evens strongly predicted deflation. If the BoE had put more weight on stabilizing inflation expectations then the policy response in September 2008 would have been far larger.

Furthermore, inflation break evens did not recover to 2.5% until midway through 2010, 18 months after the crisis started.

"The public's inflation expectations have been above 2% for a long time,"

But market inflation breakevens haven't. The mean daily short term inflation break evens 1/05/97-8/09/08 were 2.84% (SD 0.47), 9/09/08-27/04/12 they have been mean 2.00% (SD 1.35). The BoE have been keeping inflation expectations too low.

Have a look at the BoE's inflation breakevens datasets:

http://www.bankofengland.co.uk/statistics/Pages/yieldcurve/archive.aspx

The market expectations of RPI are consistent with future monetary policy being relatively tight and headline CPI being relatively low.

Surely this implies low expected AD? So it's hardly surprising that investment has not taken off. Investors are doubtful that there will be sufficient AD to make a return on their investments. A nominal GDP target, or a price level target would solve this co-ordination problem.

"fixing the banks is therefore a priority"

Right, nominal debts are too high relatively to nominal incomes. How do you propose fixing the banks? Increasing capital ratios and reducing their lending, i.e. less debt? Wouldn't it be less painful to just raise nominal income?

A nominal GDP target would be a much better policy response than the combination of headline inflation targeting and fiscal austerity. (Fiscal austerity which _caused_ headline CPI to rise above target).

At the very least the BoE should provide forward guidance on monetary policy, and target core or CPI-CT i.e. "the BoE will keep interest rates at zero until X", as the Fed has done.