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Wednesday, August 9, 2023

Inflation Or Nominal GDP Targeting? Whatever.

Nominal GDP targeting is the latest mainstream fad, which is allegedly going to improve central banking when compared to inflation targeting. In a certain sense, I have some sympathies. If a central bank could stabilise nominal GDP growth, it has abolished the business cycle. I am in favour of abolishing the business cycle. Doing so would not solve all economic woes, but it would be the most that can be hoped for from macroeconomic stabilisation policy. Unfortunately, there is no reason to believe that the central bank can wave a magical expectations wand and abolish the business cycle — despite the claims of some Market Monetarists.

There are two main variants of nominal GDP targeting.

  1. The central bank has its “we want inflation to be 2%” mandate replaced by “we want nominal GDP growth to be 5%.” My view is that once we take into account how inflation targets work in practice (as outlined in my previous article), nothing much changes in central bank behaviour (as described below).

  2. A GDP level target — there is a target level of GDP that rises by 5% per year — is going to end very badly.

I will take these in turn.

“Nominal GDP Growth of 5% in 2 Years”

As I previously argued, central banks do not attempt to counter-act every wiggle of the economy. The process of interest rate smoothing — “gradualism” — makes that impossible. However, this is not how neoclassical models work, which makes any description of an “improvement” by switching policy targets misleading.

To repeat my arguments from the previous article, central bankers are not too concerned about any immediate deviation of inflation from their target. Instead, their objective is that the economy settles into steady growth consistent with the policy target at the end of their forecast horizon. That is, “2% inflation in 2 years.”

If inflation has settled into a steady rate, nominal GDP is also going to be assumed to be growing at a steady rate. Which means that “2% inflation in two years” directly implies “x% steady nominal GDP growth in two years.” And it appears that the people pushing a 5% nominal GDP growth target think that “x%” is going to be pretty close to 5%.

This means that in practice, nothing has changed from the perspective of policymakers — they are going to attempt to do the same thing (stabilise the economy). However, replacing inflation with nominal GDP is replacing what should be an understandable objective (as writing my inflation primer is making clear, that might not be the case) that has direct implications to households and firms to an even-less well understood objective that has limited implications to individuals. Even though nominal GDP matches nominal gross domestic income, that is not an average household income: it includes other sectors. We have been hearing lectures for decades from neoclassical economists that “anchoring inflation expectations” is incredibly important, and now they want to throw that away? With an inflation target, you have a baseline for a “cost of living increase” in wage negotiations, but a nominal GDP target does not offer us that information.


I see two lines of attack against my view that a 2% inflation target de facto implies a 5% nominal GDP growth target.

  1. The first is that the central bank could believe that the steady state nominal GDP growth rate is lower than 5% if inflation is 2%. This only is an issue if the expected nominal GDP growth is quite low (say 3%), which implies a low real GDP growth rate (if we ignore the gap between the GDP deflator and the consumer price index in the inflation target). (The uncertainty about potential growth means that central bankers can gloss over smaller gaps.) In that case, the central bank would need to say to the politicians: are you sure you only want 2% inflation? Whether or not politicians are willing to crank up desired inflation is a political question. And if this period of low real growth is a secular phenomenon, there is no reason to believe that the private sector will not be able to adjust to low nominal growth. (Note that if sustainable real growth is high, and 2% inflation is consistent with 6+% nominal GDP growth, trying to force nominal GDP growth to 5% is a bad idea.)

  2. What if there is some shock that temporarily raises inflation and lowers real growth? If central bankers reacted to every wiggle in inflation this would create a policy error: the central bank hikes rates when real growth is weak (because of inflation) whereas a nominal GDP targeting bank would keep policy steady. However, the point is that is not how they behave in the real world. Central bankers are anxious about “excess capacity” measures (e.g., the unemployment rate versus NAIRU), and falling real GDP would be assumed to create excess capacity. As a result, sensible central bankers would look through the inflation spike, as they would argue that it would be transitory. There are exceptions — the brain trust at the ECB hiked rates in 2008 in response to an oil price spike. However, the other major central banks did not make that error.

Level Targeting

Level targeting changes the targeting framework — instead of worrying about the rate of change, the objective is to steer the target index (price index, level of nominal GDP) to a target level that grows at a certain percentage rate. Assuming that the economy starts near the target level, if the growth rate deviates in one direction or another, the level of the actual index will depart from the target. This implies a need to overshoot in the other direction in the future to return the index to target.

For example, assume we start with nominal GDP at target. If we have two years of sluggish 4% growth, nominal GDP would roughly end up 2% below the target that grew at 5% per year. If the central bank wanted to close the gap in one year, it would need to push on the “faster growth now” button and get nominal GDP growth up to 7% (5% + 2%).

Average inflation targeting is very close to this concept, except that you ignore historical data from before the average calculation period.

In neoclassical models, this technique has amazing abilities to stabilise the economy. However, those models are ignoring time consistency: commitments to do something in the future to compensate for something in the historical record are not particularly credible. As far as I can tell, the same neoclassical economists can pivot from “fiscal macro stabilisation policy is biased towards inflationary policy because of time inconsistency” to “level targeting is an optimal policy framework because we can ignore time consistency.”

Let us say that the economy overheats for a period of time, with both consumer price inflation and nominal GDP overshooting desired levels. Level targeting implies a future policy of slamming the brakes on and holding them down until the overshoot is corrected. And then what happens if the economy does not magically go back to the desired growth rate as soon as the target is achieved? Well, policymakers have to crank up stimulus so that you overshoot the target growth rate to catch up to target. (And guess what happens then!)

Alternatively, policymakers might say “Hey, this is stupid, we will just throw the big deviation from target down the memory hole” and just try to achieve the target growth level going forward. It is a safe bet that will be far more popular than an aggressive deliberate stop/go policy (other than from the hard money gang who cheer on deflationary recessions).

One might respond: “No, we will not be aggressive! We will steer the index back to target by a steady mild over-/under-shoot of the target growth rate.” That is, if we undershoot the growing target level, the central bank will try to target 5.5% growth to slowly reverse the error. But given the uncertainty involved in policy making, it is rather silly to believe that policymakers are going to able to differentiate between hitting 5% or a 5.5% growth rate target.

Concluding Remarks

Nominal GDP targeting is the latest epicycle neoclassical researchers are providing to “improve” monetary policy. So long as the idea of level targeting is dropped, I do not think it will matter (while level targeting is just a policy error waiting to happen). However, this is just creating an illusion of research progress, distracting from the major policy misses we have seen since the mid-2000s. 

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(c) Brian Romanchuk 2023

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