The review of the United Kingdom's monetary policy framework published alongside the budget on March 20 reveals that the UK Treasury has ruled out replacing inflation targeting with nominal GDP targeting. That is a shame. Nominal GDP targeting would provide more space for the Bank of England to support the recovery in the near term while maintaining a credible nominal anchor and introducing a more robust policy framework for the long term. While it is no silver bullet, nominal GDP targeting would be preferable to the changes set out in the review.
Would a shift to nominal GDP targeting represent a big change in the United Kingdom's monetary policy framework? In the United Kingdom the government (Chancellor of the Exchequer) sets the remit for the Monetary Policy Committee (MPC) of the Bank of England. The Bank has operational independence in choosing the tools and policies to meet its objectives. The current MPC remit states that "the objectives of the Bank of England shall be: (a) to maintain price stability, and (b) subject to that, to support the economic policy of Her Majesty's Government, including its objectives for growth and employment."
Recent policy decisions show that the MPC already cares about stabilizing output as well as inflation. The MPC has shown itself willing to tolerate higher inflation in the near term to avoid exacerbating the recession with tighter policy. This is nevertheless consistent with its remit because the best collective judgment of the committee has been that inflation would fall back to target in the medium term (within two to three years). Recent communications go even further in this direction. The MPC is now ready to tolerate higher inflation even in the medium term and to bring inflation to target over a longer horizon than it sought in the past. It may therefore seem that a move to nominal GDP (NGDP) targeting would amount to nothing more than the recognition of output in the Bank's objective function with little practical change to the way policy is made.
To appreciate the difference between inflation targeting and NGDP targeting, it is important to distinguish between targeting the growth rate of NGDP and targeting a path for NGDP. Under the former, as under inflation targeting, policy is undertaken in a purely forward-looking manner. The central bank seeks to meet the growth target within the time horizon over which monetary policy affects the target variable, ignoring past misses. Targeting the path for NGDP, on the other hand, is more akin to targeting a price level. Within this framework, policy becomes history dependent. The central bank still bases its policy on forecasts for the target variable, but it must compensate for past deviations from the target path/level.
The targeting of a path for NGDP has generated interest in the economics profession in recent years. The immediate concern motivating this interest is the weakness in advanced economies and the slow pace of recovery from the Great Recession, despite near-zero policy rates and large doses of quantitative easing (QE). In this context, the argument of the economist Michael Woodford for NGDP targeting has been particularly influential. The history-dependence of this framework is the key to its success at the lower bound. Compared to inflation targeting, targeting a path for NGDP implies a longer period during which interest rates remain at the lower bound. This is because the collapse in NGDP below the target path during the Great Recession would need to be compensated with higher NGDP growth in the future.
Expectations of lower future policy rates would help to push down on the full range of long-term interest rates relevant for economic decisions, stimulating spending and investment. Because a switch to NGDP targeting implies looser policy while the economy recovers (though not in the long term as explained below), it may be accompanied by temporarily higher inflation expectations, which would further push down on real interest rates and thus help to stimulate activity. Woodford notes that the short-term boost to activity would be particularly large in the current situation when the lower bound on policy rates is binding because of the absence of monetary policy tightening that higher spending would prompt in normal times.
Does NGDP represent a new and powerful tool in central banks' arsenals?
In principle, one could argue that because it represents a promise about what policy will do once the lower bound no longer binds, it remains powerful even if other policies, including QE, lose their effectiveness at the lower bound. To my mind, however, NGDP targeting is best seen as complementary to the full range of unconventional policy tools that remain effective, to various degrees, at the lower bound. Mere talk is not enough. Central banks need to act to convince markets of their commitment and ability to meet the target. QE has been less effective than the Bank of England hoped. The search for more effective tools that deliver a favorable trade-off between real growth and inflation should continue. A switch to NGDP targeting in the current context of above-target inflation would give the Bank of England more space to pursue unconventional policies more aggressively in the near term while maintaining a credible nominal anchor in place.
Changing well-established policy frameworks to deal with short run problems is rarely a good idea. Fortunately, NGDP targeting has an important advantage over inflation targeting, even from a long-run perspective. It is more robust in the face of various shocks in the sense that its prescriptions do not often go against what a policymaker with full discretion and who is concerned about both real activity and inflation (as most of us are) would follow.
The obvious example is a shock to the country's terms of trade, such as a spike in oil prices. An NGDP target would distribute the impact of an oil shock equally between a higher price level and lower real GDP, which is arguably the most that can be asked of monetary policy. Strict inflation targeting would call for stabilizing inflation and absorbing the shock fully through lower real output—an inferior outcome.
In practice, however, inflation targeting has been more flexible than that. But there is a limit to how far a central bank can tolerate higher inflation in the near term before it starts to lose credibility—something which the Monetary Policy Committee at the Bank of England has been continuously worried about over the past few years in the face of repeated price level shocks. In the other direction, an NGDP target would have led to tighter policy in the United Kingdom in the 2000s, when cheap Chinese imports pushed down on Consumer Price Index (CPI) inflation. Instead, inflation targeting called for a boost to domestic demand and inflation in order to compensate for low imported inflation.
Despite a growing number of fans, there has been no shortage of economists calling attention to potential problems with NGDP targeting. Are these problems serious enough to warrant sticking with the framework we know, particularly in these difficult and uncertain times? Professor Charles Goodhart, a former member of the MPC, notes that the nominal income gap—that is, the gap between current nominal GDP and the target path—is sensitive to the target growth rate of NGDP and the starting date. That may be true, but the decision on the two does not need to be arbitrary. As a simple suggestion, one might want to choose a growth rate of the target path equal to the average long-run growth rate of real GDP (around 2.7 percent in the United Kingdom over the 1955–2002 period—i.e., ignoring the most recent boom and bust) plus an inflation target of 2 percent. As a starting date, one might choose one where real GDP was close to its long run trend path and inflation was close to 2 percent.
As it happens, early 1997, which also broadly coincides with the time when the Bank of England was made operationally independent, is one such plausible candidate for a starting date. Figure 1 plots nominal GDP since 1997 against a target path of 4.7 percent annual growth. It illustrates the point made above: that monetary policy would have been tighter over the 2003–07 period under NGDP targeting and would have given the Bank of England more space to support recovery in recent years.
Source: Organization for Economic Cooperation and Development.
A more sophisticated method for estimating the trend growth rate of real GDP may be preferable to one using a simple average of the past. One cannot dismiss the possibility that trend growth is from time to time subject to shifts that are difficult to identify in real time. This worry is pertinent in the United Kingdom at the moment. Under NGPD targeting, uncertainty about the long-run growth rate will inevitably translate into uncertainty about long-run inflation. But the range of that uncertainty would be quite small by historical standards and minuscule by comparison to the inflationary 1970s. Moreover, there is no reason to set the target path for NGDP in stone. Perhaps an independent committee of economists could produce an updated estimate of trend real GDP growth every two or three years with the understanding that the target path would be adjusted to reflect the new estimate plus 2 percent.
It is important to ask further whether uncertainty about inflation is more damaging to the economy than uncertainty about nominal GDP. The latter is clearly more important for stabilizing employment because employers' ability to pay their wage bills depends more on nominal spending growth than on the rate of inflation per se.
A further practical problem with implementing NGDP targeting relative to inflation targeting is posed by the relative infrequency of data as well as publication lags and revisions. I don't see how this is a big problem within a framework that in either case targets, not current, but forecast values of the relevant target variable. Even within an inflation-targeting framework, current inflation plays only a very minor role in informing the inflation forecast at the relevant horizon of two to three years in the future. Moreover, more timely and frequent indicators of GDP, such as industrial production and expenditure surveys are available to improve the assessment of current nominal spending.
Another worry about the consequences of NGDP targeting in the longer term relate to history-dependence. While NGPD targeting may help by requiring more monetary stimulus in a demand slump, it would—by the same logic—require greater tightening following a positive shock to nominal demand that resulted in a deviation from the target path on the upside. In other words, under NGDP targeting, central banks may be required to "generate" recessions more often than under an inflation targeting regime where bygones are bygones. Such a policy would be hugely unpopular. One might wonder whether a framework with such implications would survive the first such episode.
I concede that this risk is real. But one needs to set the risk against the considerable benefit of a more aggressive response to recessions outlined above. I would tentatively argue that, over the long run, the benefits are likely to outweigh the costs for two reasons. First, the nature of economic cycles is such that recessions and crises tend to hit suddenly and lead to large drops in real GDP, whereas booms and bubbles tend to build up over time. Thus it is far less likely that an economy would find itself suddenly very far away from the target path on the upside before the central bank had a chance to respond. Moreover, the so-called Lucas critique applies here—under a credible NGDP targeting regime, deviations from the target path would automatically generate expectations of future policy changes irrespective of how fast policy responds now. This self-correcting mechanism would act to put a brake on incipient booms (even though it may not stop bubbles in certain asset prices altogether) just as it would make recessions less severe.
Second, the lower bound on interest rates introduces a dangerous asymmetry in the ability (or at least efficacy) of the central bank to respond to large shocks. A large positive shock can always be met with higher interest rates, whereas a large negative shock eventually runs up against the lower bound beyond which central banks have to resort to unconventional and inevitably controversial tools. Together these two claims suggest that the design of the policy framework should focus more on enabling a speedy and robust response to recessions rather than the far more remote and less intractable possibility that the economy may find itself far above the target path.
Instead of a wholesale change to the United Kingdom's monetary policy framework or a change to the inflation target, the chancellor opted for a fudge. He reaffirmed an "absolute" commitment to the 2 percent inflation target, which "applies at all times," while encouraging the Bank to support the recovery by utilizing new unconventional policy tools. One of the tools cited in particular was explicit forward guidance, "including intermediate thresholds in order to influence expectations and thereby meet its [i.e., the Bank's] objectives more effectively." This strategy is, unfortunately, internally inconsistent for two reasons. First, significant further stimulus when inflation is forecast to remain above target for the next three years would start to conflict with the lexicographic preference for inflation in the MPC remit. The two- to three-year horizon over which the Bank has traditionally sought to meet the target is not arbitrary. It is determined by the time it takes for monetary policy changes to affect inflation. Greater flexibility to meet the target over a longer horizon is therefore not strictly consistent with the current MPC remit.
Second, forward guidance, by design, implies that the commitment to an inflation target does not apply equally at all times. Forward guidance involves a conditional commitment by the central bank to keep monetary policy loose until some intermediate threshold or combination of thresholds (for example for output and inflation) are achieved. It is therefore a temporary way of introducing history-dependence and works in the same way at the zero lower bound as NGDP targeting. As I discussed above, the point of such a policy is to convince the public that the reaction function of the central bank has changed and that it would be willing to maintain loose policy for longer than it would have done in the past. In other words it represents what Paul Krugman calls a "commitment to be irresponsible"—a commitment to higher growth and inflation for a period in the future to make up for lost ground when policy was constrained.
The chancellor is trying to have it both ways and leaves it to the Bank of England under the new governor, Mark Carney, to figure out how. Adoption of a nominal GDP target would have been more transparent and honest.