NGDP targeting could change the way we manage inflation

So you should know what it is. Stephen Gordon explains

by Stephen Gordon

(Adrian Wyld/CP)

The original goal of this post was to answer the following questions:

  1. What was Mark Carney talking about in his December speech entitled “Guidance“?
  2. What is NGDP targeting and why are people talking about it?

It turns out that that before I could figure out what to say about those two questions, I had to talk about two other things first: inflation targeting and price-level targeting.

There’s really no great mystery about what the Bank of Canada does and why: it has an explicit mandate from the government to conduct monetary policy in such a way as to ensure that inflation rates stay between one and three per cent per year, with two per cent being the de facto target. It’s been doing this for more than twenty years, and successfully, too:

An important feature of Canada’s inflation-targeting regime is that it is forward-looking. Milton Friedman famously remarked that monetary policy takes effect with “long and variable lags”; current decisions about the conduct of monetary policy are made with an eye on what is likely to happen six to eight quarters from now. Having a forward-looking target also means that past mistakes are ignored when planning for the future. The most recent data show Consumer Price Index (CPI) inflation running below target, but that is only of concern to the Bank of Canada insofar as it affects its assessment about what is likely to happen in mid-2014. The fact that year-over-year inflation in was only 0.8 per cent in November does not mean that the Bank will try to compensate by attempting to engineer an inflation rate above two per cent in the future.

So even though inflation targeting makes it relatively easy to make forecasts about inflation—two per cent a year would be the safest bet—the fact the the Bank treats past deviations from target as bygones to be forgotten means that forecast errors accumulate with longer horizons.

Now, uncertainty about anything is costly, so it’s worth revisiting the current setup with an eye to reducing uncertainty.

Suppose the Bank of Canada’s mandate was revised so that if inflation did run below target, it would “correct” this mistake by running higher-than average inflation so that long-run forecasts of inflation can be made with more certainty. This is the idea behind price-level targeting (PLT). Instead of targeting the rate of CPI inflation, the Bank would target the actual level of the CPI. If the growth of CPI fall below trend, the Bank would be expected to generate above-trend inflation rates in order to return to the target.

Surprisingly enough, it looks as though the Bank of Canada has in fact been conducting this policy for the better part of two decades:

Periods of below-trend inflation have been almost exactly offset by periods of above-trend inflation: average annual inflation between January 1995 and November 2012 was 1.94 per cent. The people at the Bank of Canada will tell you that this is simply a happy coincidence, but it’s a handy thing to remember: if the Bank’s mandate were changed to a price-level target, the path of CPI wouldn’t look much different than the current one.

There are a couple of reasons why price-level targeting might be a good idea:

  1. More aggressive counter-cyclical policy. Inflationary pressures are reduced during recessions, and the Bank’s response is to bring inflation back up to target. But under PLT, the Bank’s goal would be to generate inflation that is above target in order to offset the effects of the recession. This extra monetary stimulus would also have the effect of making recessions shorter and less severe under PLT than under inflation targeting.
  2. More effective monetary policy. One of the most important ways in which monetary policy works is through its effects on peoples’ expectations of inflation—this was the subject of Mark Carney’s recent “Guidance” speech. For example, the Bank of Canada’s policy rate is now at one per cent, so two per cent expected inflation implies a real interest rate of minus one per cent. But if it were known that the Bank was aiming at (say) four per cent inflation in the near term in order to return the price level to its trend, then the same nominal policy rate of one per cent would imply a real rate of minus three per cent, and would have a correspondingly larger effect.

A problem that PLT may have but which inflation targeting does not is dynamic inconsistency. Monetary policy may become more effective if people believe that inflation will go above trend after the economy has recovered. But once the recession is over, inflation returns to target and the economy returns to full employment, the central bank would be sorely tempted to simply declare victory and forget about trying to engineer a period of higher-than-average inflation. And if the situation were reversed—if there had been a temporary spike in inflation—the central bank may not be inclined to adopt a contractionary stance and risk a recession in order to return the price level to target.

Still, the Bank of of Canada has spent a lot of time researching the matter, and most people involved—both inside and outside the bank—seem persuaded of the theoretical merits of PLT. When the inflation targeting mandate came up for renewal in 2011, there was some speculation that the Bank would switch to PLT.

It didn’t, for what is to me a very compelling reason: inflation targeting was not broken in Canada, and the improvements offered by PLT had to be very large indeed to justify tinkering with a policy regime that had served us well. Moreover, it was not at all clear that the communication issues raised by PLT would work smoothly in practice. Under inflation targeting, everyone knows the inflation rate that the Bank of Canada intends to deliver: two per cent. But under PLT, these inflation objectives would vary continually. Depending on whether or not the CPI was above or below target, the Bank would announce inflation targets above or below two per cent, and converging to trend over the medium term. In theory, people would continually revise their inflation forecasts as the Bank revised its inflation objectives. We don’t really know how things would actually work in practice, but it seems clear that communications from the central bank—or guidance—would become even more important than it is now.

This is the part where I finally get to talk about NGDP targeting. I spent a lot of time talking about price-level targeting for three reasons. The first is that PLT has been the subject of much debate in Canada, and we may see it come up again. Another reason is that the research on PLT is—so far—more extensive than on NGDP targeting. But the most important is that the arguments for PLT are similar to those in favour of NGDP targeting: if you can understand why PLT might be a good idea, you can understand why some people are so keen on NGDP targeting.

An NGDP targeting regime would work in much the same way in which PLT does: the central bank targets nominal GDP and adjusts monetary policy accordingly. Nominal GDP is not adjusted for inflation, and can be roughly interpreted as being the product of the price level and real GDP. The advantages of NGDP targeting are the same as PLT, only more so. In a recession, the central bank wouldn’t be satisfied with getting inflation or even the price level back to trend; it would try to increase prices even higher in order to return NGDP to its trend. Monetary policy during a recession would be even more aggressive than under a PLT regime and much more aggressive than under inflation targeting.

Suppose that instead of a two per cent inflation target, the Bank of Canada had a NGDP target that was growing by (say) five per cent per year—two per cent inflation plus three per cent real growth:

The Bank of Canada believes that its current stance is consistent with its inflation target. If it were following a PLT, Canadian monetary policy might be more loose, but the current deviation of CPI from a two per cent trend isn’t all that large by historical standards. But if we had an NGDP target, the Bank of Canada would be much more aggressive than it is now: the policy interest rate would probably be still at zero, and it may have already resorted to quantitative easing. It is this feature that makes NGDP targeting such an attractive idea for places like the U.S. and the U.K., whose economies are still in deep recession. A mandate to do whatever it took to return NGDP back to trend could go a long way to accelerating their recoveries.

As with PLT, the biggest challenge with implementing NGDP targeting is communications. As Carney noted in his speech, central banks would be required to provide clear, credible and continual guidance to private sector forecasters in a complicated environment, and this task is especially difficult now that policy rates are at or very close to their lower bounds. Moreover, the credibility of the central bank’s guidance becomes even more important, because it will have to contend with the dynamic consistency problem. The private sector may not always believe a central bank that has a strong incentive to go back on its word.

The case for NGDP targeting is a difficult one to make for Canada in the near term: it’s hard to justify fixing inflation targeting when it’s not obviously broken. As I said, it is much easier to make the case for NGDP targeting in the U.S. and the U.K. But in the event that the Federal Reserve and/or the Bank of England adopt NGDP targeting and figure out how to meet the communications challenges, then when the Bank of Canada’s mandate comes up for renewal in 2016, it might no longer be a question of abandoning something that works for something that’s not been tried before: it might be a question of abandoning something that works for something that demonstrably works even better.


NGDP targeting could change the way we manage inflation

  1. Helpful information … especially for those of us who are
    interested but not specialists.

  2. I guess here and now is as good a time as any to tell people that I’m going to be moderating the comments on my posts with a firm hand from now on. Here are my rules:

    - No personal attacks. On anyone.
    - Stay on topic.

  3. I read a lot about NGDP targeting on the blog “Economist’s View” which slants towards the centrist Keynesian interpretation of the economy. (That and raising the inflation target in the medium term.)

    No doubt the 30-year war against inflation has caused a lot of collateral damage. It seems the focus was really on busting wages (and wage-push inflation.) The full-employment monetary policy of the post-war era eventually caused the high inflation of the 1970s (triggered by oil supply shocks.) Over the past 30 years, central banks manufactured deep recessions to break the back of inflation (early 1980s and early 1990s recessions) paving the way for corporate downsizing.

    In the process, we accumulated most of our government debt (from 17% debt/GDP to 85%) from high-interest debt-servicing costs. Now the economy is in a liquidity trap (interest rate needed to spur a recovery is below zero; Japan has be stuck in the trap, with interest rates below 1%, for 17 years…)

    The right level of inflation is really a delicate balancing act. (The 2% target is an arbitrary number.) Too much inflation punishes savers and unjustly rewards borrowers. Too little, the opposite. I don’t think any automatic formula will do the job because the economy is much more complicated that that.

    But it looks like we’re back to square one: “To-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time—perhaps for a long time.” (J M Keynes 1930)

    • Do you think the war against inflation has contributed to the deepening differences in incomes within countries, between classes?

      • Definitely. When central bankers were fighting inflation they raised interest to very high levels at times (as high as 22% in the early 1980s; presently 1%.) This allowed wealthy investors to get high returns on guaranteed investments. The recessions allowed corporations to downsize, which boosted share value and justified pay increases for corp execs.

        On top of that there was also 30 years of failed free-market reforms which caused inequality to soar:

        A) Reckless tax cuts. (Mr. Gordon posted in another blog that this was part of a “starve the beast” scam: 1) cut taxes; 2) manufacture a budget crisis; 3) justify deep spending cuts; 4) go to 1.) This destroyed progressive taxation.

        B) Free-trade globalization. First-world workers now have to compete with countries that abuse and oppress workers, 19th-century style. This has led to many job losses and put a downward pressure on wages.

        C) Cuts to social spending. Social programs level the playing field and provide people with equality of opportunity. Cuts are winding back the clock to before the post-war era.

        The really scary thing is that living standards will continue to deteriorate. That’s why we must return to the centrist economics of the post-war era that created modern living standards.

        One-sided right-wing economics not only cause soaring inequality, they also kill economic growth (the 2000s was the worst decade for real GDP growth since the 1930s; the 2010s will be even worse…)

        • Ok I hear you. The rest after the inflation-part is coherent with what i belive. The part about inflation i dont fully understand. Why do even leftish economists believe in, and defend, free trade liberalization, if this is the result from it?

          I have another question for you, that is off topic, but you can probably help me. In krugmans latest post, about “money morality” he writes:

          “For many people on the right, value is something handed down from on
          high It should be measured in terms of eternal standards, mainly gold; I
          have, for example, often seen people claiming that stocks are actually
          down, not up, over the past couple of generations because the Dow hasn’t kept up with the gold price, never mind what it buys in terms of the goods and services people actually consume.”

          What does he mean exactly with the last part? That even though the value of gold has risen higher than the Dow index, an investment in stocks would have generatet a higher value in forms of goods that we want? Or does he simply mean that stocks has been a good investment too, but not as good as if one would have invested in gold instead??

          • From what I’ve read, left-leaning economists do not support free trade. They support fair trade. Fair trade is based on common regulation blocks instead of free-trade blocks. For example, considering it is illegal to exploit child labor in first-world countries, it makes no sense to allow corporations to bypass the law by moving production to countries that do allow it. It’s the same with all labor regulations as well as environmental regulations, public education and other kinds.

            The fact is, modern living standards (which were unprecedented in history,) were created in the post-war era with labor regulations, public social benefits and the rising strength of unions. If it weren’t for this government intervention in the economy, first-world workers would still be poor and exploited like they were before this period.

            So in order to create rising living standards in developing countries, so people there can buy first-world goods and services and keep the global economy stable and strong, developing countries have to adopt first-world regulations.

            Free trade does the opposite. It allows corporations to erode first-world regulations and living standards by moving producton to countries that don’t have them in place. This race to the bottom is destroying first-world markets and economic growth. It is unsustainable and will eventually lead to depression.

            BTW, in the post-war era, we had no free-trade deals, yet we had phenomenal economic growth and rising living standards for all segments of society. Since free-trade, GDP has steadily eroded and only the rich thrived. The 2000s was the worst decade for growth since the 1930s. This decade will be worse.

            In short: the policy was an abject failure.

          • I think Krugman is saying the gold standard is foolish because real the measure of money is what you can purchase with it in goods and services. All that matters is price stability. (Too much inflation erodes purchasing power giving borrowers an unfair advantage; too little, or deflation, causes recession or depression.)

            As Keynes said, the gold standard is a barbarous relic. The economy grows at an exponential rate (it’s based on savers and investors getting a return on their savings/investments.) So it’s impossible for the money supply to keep up with size of the economy if it’s based on gold.

            The reason why the price of gold is so high now is because people are hoarding money. Businesses and investors have little faith in the economy so they are buying gold and bonds. They are expecting deflation, so they would rather keep the value of their money intact instead of losing it in risky investments and a bear stock market. (Of course, they would prefer a strong recovery, a bull market and a good return on their investments.)

            This brings us to the entire NGDP targeting issue. Right now the 2% inflation targeting is making investors nervous. They don’t want to invest their money and take losses because the central bank prematurely raises interest rates and kills off the recovery. If NGDP is targeted, investors can be assured the economy will fully recover and start to overheat before action is taken.

            Krugman appears to favor raising the inflation target in the medium term (say 4%, which is not really high, the kind of inflation we had in the 1980s.) If investors expect inflation, they would rather invest their money than buy gold or bonds, because hoarders would see their money depreciate (from inflation.) With money invested in the economy, this would create a bull stock market, an (actual) strong recovery, jobs and eventually allow the central banks to raise interest rates back up to normal levels.

            (Krugman talks about this in “A Return to Depression Economics.” He uses an example of a baby-sitting co-op to explain how the economy operates. This baby-sitting co-op underwent a “recession” because people were hoarding coupons for baby-sitting instead of using them up.)

          • Thank you sir. This made me wiser. Are you an academic economist or self supplied with knowledge?

          • Yes, my knowledge comes from reading books and keeping up with articles on the economy.

            Unfortunately, macroeconomics is a field where the title “economist” means absolutely nothing. The profession is polluted with agenda-driven charlatans who have no compunctions cooking data to justify ethically-bankrupt policies (like “starving the beast.”) Scientists and doctors managed to drive out the crackpots and quacks. But since economics deals with money and power, the rich and the powerful interfere in the process and keep it from developing into a science.

            I find the Keynesians are the ones with the most integrity And if evidence is any measure, their system was the most successful in human history (in the post-war era; but also presently in northern Europe.) The free-market libertarians, with their economic fundamentalism, caused two global economic meltdowns (1929 and 2008) and all the problems we are facing now.

            Paul Krugman has an interesting term for failed policies being peddled by the conservative media: zombie economics: “policies that should have been killed by the evidence that all of their premises are wrong, but which keep shambling along nonetheless. And it’s anyone’s guess when this reign of error will end.”

  4. I really enjoyed this article. I agree with PLT and it seems clear to me that the canadian economy is still suffering from cyclical unemployment. The labor market appears to be going through what Krugman calls internal devaluation, and returning to the 2% path would speed up the process.

    Is not a NGDP target ineffective under a negative supply shock? During the oil shocks, you had a fall in ngdp growth, rising inflation and rising unemployment (in the US). Had the Fed followed and NGDP target, would that not have been even more inflationnary?

    • In the 1970s, real GDP growth was fairly high during non-recession years (over 5%.) That’s higher than almost all years during the 1980s and 1990s. With inflation at 10% or higher, NGDP growth must have been really high.

      I think in order to fight inflation we have to take the Keynesian approach, which is to use many different tools, instead of monetary policy alone. When the economy is overheating, governments can cut back on infrastructure spending and raise taxes to dampen the economy. When the economy is in recession, it can spend more money and cut taxes to boost demand.

      This approach worked very well during the post-war era, even though there was poor policy coordination and lags between action and the actual state of the economy. When government works closer with its central bank, it can bring fiscal policy in tune with monetary policy and save taxpayers money on debt-servicing costs (and other collateral damage) by tackling inflation more efficiently.

      Governments can also use regulations to prevent inflation (e.g., tougher mortgage rules to stop a speculative housing bubble.)

  5. What if potential GDP has declined since the 1990s? If inflation is on the horizon do you just dismiss the possibility that that’s because potential GDP has declined and keep your foot on the gas? How high would inflation have to go before the admission came that the inflation is due to the economy running over potential? How would the central bank then get its credibility back?

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