The Times is reporting that the Treasury is setting up an internal unit to look into the wisdom of revising the Bank of England’s ‘flexible’ 2% CPI inflation target. Mark Carney, the incoming Governor of the Bank who will replace Mervyn King in June, mentioned the merits of adopting NGDP (National Gross Domestic Product) level targeting in a speech last December, launching a frenzy of speculation.
Considering the enormous effect expectations of future monetary policy changes have had in places such as Japan, it may be that the talk of NGDP targeting is partly behind the substantial rise in the FTSE and fall in the pound since around the New Year. Recently, however, both he and George Osborne have seemed to be rowing back on their support for their policy. Therefore, it’s worth reviewing – as the Treasury is – the case for listening to Vince Cable and targeting the level of nominal GDP instead of inflation.
When discussing NGDP targeting, too often politicians and commentators see it as some kind of policy of ‘targeting growth.’ To clarify, NGDP targeting requires the Bank to make no assumptions about the rate of real output growth. A better way to think about it is targeting the amount of nominal spending in the economy.
There are several advantages to targeting nominal spending as opposed to rises in the price level. Perhaps the most major reason is that NGDP is a better indicator of demand in the economy. If there are negative ‘shocks’ to the real economy – a rise in oil prices, say – then it will raise inflation, but that will not be an indicator that the economy is overheating. It would not be appropriate for the Bank of England to tighten monetary policy, reducing import prices by ensuring that people are too poor to afford them. Because a real shock would raise prices but reduce real growth, NGDP would be unaffected, allowing the central bank to ‘look through’ real shocks and avoid tightening monetary policy too much in response to sudden bursts of inflation that are outside their control.
In 2008, for example, the Bank would have been able to see past commodity price rises and the realisation that perhaps we weren’t as productive as we thought we were, and realise that demand was collapsing. They might have prevented the banking crisis from becoming systemic and leaching through into the wider economy.
Similarly, in the 1970s the Bank would have been able to see past the supply side effects of the oil crisis and see that accelerating NGDP growth was also pushing up prices and causing a wage-price spiral. The worst of stagflation might have been prevented. The story, of course, cuts both ways – if there are positive supply shocks, the Bank would avoid easing and overheating the economy.
There’s a fairly strong case that in the early noughties, falling import prices thanks to cheap Chinese production and the strong pound led monetary policy to be too easy, pushing NGDP growth above trend and helping to inflate the housing bubble. NGDP targeting, then, isn’t just a recipe for monetary easing – it would promote stability at all points of the business cycle.
Another advantage of nominal GDP targeting is that it’s much easier to measure than inflation. Inflation requires you to estimate how much prices are rising by. There are several different measures, and all of them give wildly different results, each with wildly different implications for the required stance of monetary policy. The Consumer Price Index that the Bank currently targets is going to be 0.3% higher for the next three years because of the increase in tuition fees, which is not a rise in the price of higher education at all but rather a change in who pays for it. The VAT rise in 2011 created similar distortions that arguably caused the Bank to miss the derailing of the recovery.
Measuring nominal spending is comparatively easy. Concerns about revisions to the data are overblown because headline NGDP growth would be only one of the factors affecting the Bank’s stance – inflation expectations, asset prices, unemployment and other indicators would also be used to estimate the future path of nominal GDP and therefore the appropriate policy stance. There are also ways of adapting the policy regime to compensate.
The advantages of targeting NGDP rather than inflation are numerous and sceptics tend to overstate their case. It’s far easier for the government to tighten fiscal policy and deal with the deficit when monetary policy is co-operative; austerity may be hurting the economy right now, but there’s no reason why it has to be that way. Even absent level targeting, which I’ll address in a future post, nominal GDP is the key to a more stable monetary framework which would dramatically reduce the likelihood of future recessions.