The recent Great Recession destroyed a lot of economic ventures – none more so than the policy of inflation targeting. A decade of supposed low inflation and increasing output was shown to be an illusion, as we have since learnt that the consumer prices index is a poor proxy for inflation, and that bubble activity is not genuine growth. Given this failure, one might have expected economists to find an alternative, and one gaining popularity is a nominal income (or NGDP) target.
This policy has been explicitly proposed by the FT’s Samuel Brittan and is the subject of a new pamphlet by Scott Sumner for the Adam Smith Institute. It stems from the idea that central banks should alter the money supply to offset changes in demand. The practical difficulty is how central bankers can know the “right” amount of expansion or contraction to find this equilibrium. This is where Sumner’s practical suggestions come in. If the money supply multiplied by velocity (which reflects the demand for money) is constant then so is nominal income. And nominal income requires two things: (1) targeting the level, not the growth rate; (2) target the forecast, not the historic data.
There are a couple of key benefits to nominal income targeting: Productivity gains can manifest themselves in lower prices. With inflation targeting we are committed to 2 per cent inflation but if productivity is improving consumer prices should fall.
Targeting the level removes a large amount of discretion from the Bank of England. Monetary policy stops being an arbitrary policy lever and provides a macroeconomic foundation upon which economic activity can build.
By targeting forecasts, it is forward looking. In the UK now we have inflation policy driven by last month’s inflation figures. But if inflation expectations are low, then last month does not matter. Sumner’s plan for an NGDP futures market would divert attention to market expectations rather than the interpretation of past events.
Nominal income targeting is not perfect. I would quibble with the underlying assumption that the Great Recession was “merely” the result of bad monetary policy in 2008, and point to far earlier mistakes that created a housing bubble and a painful economic contraction.
I would also challenge the tools with which central banks might go about the policy objective, since there can be a fine line between “stabilising MV (money supply multiplied by velocity)” and “boosting AD (aggregate demand)”.
Given that the Bank of England seems happy to continue to overshoot its 2 per cent target, it is clear that inflation targeting no longer exists. Indeed until 2008, NGDP was growing at a fairly constant 5 per cent and the ambivalence towards high inflation now, with real GDP so low, could be interpreted as a de facto NGDP target. But if this is the direction we are headed, the MPC would be better to come out and say it. It would not solve the fundamental problems with our monetary system but it would be a marked and feasible improvement.
Anthony J Evans is associate professor of economics at ESCP Europe Business School