A point on NGDP targeting and inflation expectations

I’m increasingly hearing people call for an NGDP target.  I’m not really convinced it is superior to inflation/price level targeting to be honest.  Let me discuss below.

For a starting point, lets not make the mistake of comparing inflation targeting and NGDP target – one is a growth rate and one is a level.  The relevant comparisons should be inflation target vs NGDP growth target and price level target vs NGDP target.

The primary difference between a growth and level target is whether a central bank can “ignore past mistakes”.  If we assume that can we compare growth targets – otherwise we set a level target.  We choose growth usually, because we are focusing on expectations of the future – including past mistakes explicitly would muddy the water, and make central bank actions less credible.

So what is the difference between targeting a growth rate in prices (inflation) and a growth rate in NGDP (nominal income)?  The growth rate in prices is the inflation thing we have justified in the past – the growth rate in nominal income is a composite of higher quantities of production and higher prices.  An inflation target aims to get price growth to sit around a certain level over the long term, an NGDP growth target aims to get price level growth to sit around a certain level over the long term … the reason they do the same thing is because real growth in output in the long is “exogenous” – it is independent of the fiddling with monetary variables.

As a result, the entire difference in the target boils down to its short-run dynamics.  In the short-run, due to sticky prices, money illusion, and a whole host of psuedo-psychological explanations, there is a trade-off between inflation and unemployment … and as a result inflation and output.  Now when there is a shock, an inflation target gives us a clear path to what is going on – we respond such that inflation is back at target.  NGDP growth targeting gives us a mixed message – we will respond such that inflation*output equals our target.

Although the long-term “inflation target” is clear in NGDP growth targeting, the short-term target is not … especially if private actors can’t differentiate between “supply side” and “demand side” shocks, and so are unsure whether monetary authorities will essentially tighten policy (in the demand side case) or loosen policy (in the supply side case) after seeing the price level jump.  Now the same visual asymmetry exists with inflation targeting (due to the difference the between the shocks) but a central bank at the moment can credibly say that the change in price is in the past – and in the future the price level will grow by X%, anchoring expectations and aiding price setting.  Furthermore, it is credibility that allows the Bank to anchor expectations, and with expectations anchored this allows them to limit any deviation of output from its “natural rate” through their interest rate setting.

In the case of NGDP growth targeting, there is no anchor to a real choice variable – nominal income is something we see, but it is not the choice variable people use, like output or price.  As they can’t tell what the central bank is doing regarding a target for price or output, expectations are unclear, and there is likely to be unnecessary volatiliy and misalignments solely due to the choice of target.

Now of course there are arguments both ways – but expectations formation is the major issue to keep in mind when we think about these things.  And I’m not convinced that NGDP growth targeting has an advantage over inflation targeting here.

But what about level targeting!

Although level targeting has the disadvantage of making expectations unclear, it has an advantage during a liquidity trap.  However, a credible central bank could insert a clause in their policy target agreements that states what a liquidity trap is, and gives them jurisdiction to temporarily increase the inflation target in this state.  Problem solved.

Yes, central banks don’t seem to be responding (although I would suggest that QE is essentially the Fed stating that it will violate its target in the future) but I’d put that down to the lack of clear vision regarding whether this is a liquidity trap – it also doesn’t help that European authorities are clinically insane … I think if you had put that in the Fed’s forecasts they would have eased more aggressively.

Another advantage of level targeting is that it increases long-term certainty about the price level (both price and NDGP targets – as long run RGDP is exogenous remember 😉 ).  Overall though, NGDP suffers from the same expectation issues in the short-term that NGDP growth targeting would.

Summary

If I had to summarise what I’ve said to an economicsey auidence, I would say that I’m not convinced that NGDP growth targeting offers a superior alternative to “flexible” inflation targeting, even if both involve commitment to a state-contingent policy plan for the Bank (plans which have their advantage by informing public expectations).  The inflation target has the advantage of communicating a clear path for the price level, and it remains consistent even as the underlying rate of RGDP growth changes.