Mark Carney’s suggestion that in exceptional circumstances a central bank could target a nominal economic growth rate to help an economy out of a slump has prompted fevered debates over whether he will drastically alter policy when he takes over from Mervyn King at the Bank of England in June this year.
In Carney’s speech to the CFA Society Toronto in December the central banker cautiously indicated that owing to the “exceptional nature of the situation” faced by developed economies policymakers could justify revisiting the targets governments give to central banks.
With the traditional tool of central bank policy, namely setting interest rates, now anchored around zero central bankers have been forced to look to unorthodox measures to boost ailing economies. Although quantitative easing forms part of this arsenal, Carney said that there were other options worth considering:
“If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.”
The idea of a nominal growth target, or NGDP target, is hardly a new concept. In his Nobel Prize speech in 1977 the economist James Meade suggested that central banks should aim to maintain “total money income”:
“Perhaps the best compromise is an independent monetary authority charged so to manage the money supply and the market rate of interest as to maintain the growth of total money income on its 5-per-cent-per-annum target part, after taking into account whatever fiscal policies the government may adopt. One would hope, of course, that there would be a suitable discussion of their plans and policies between the government and the monetary authority.”
Since then the cause of NGDP targeting has had a number of champions, including Sir Samuel Brittan and Giles Wilkes in the UK and Michael Woodford and Scott Sumner in the US. In fact Woodford gave a much-discussed paper on the subject at the Jackson Hole summit last year.
However, while the Bank of England’s inflation target and the Federal Reserve’s dual mandate of price stability and full employment appeared to be working well it gained limited traction outside of academic circles. Yet with monetary policy now firmly into uncharted waters, this appears to be changing.
Perhaps the best compromise is an independent authority to manage money supply
Brittan argues that the benefits of this over the current inflation target is that balancing the growth rate with inflation should help restrain price increases during booms and encourage a faster response by central banks to an economic downturn. As he wrote in a recent Financial Times column:
“Yet the basic idea could hardly be simpler. The growth figures that dominate the headlines are of “real” gross domestic product, which means they are corrected for inflation. With nominal GDP they are uncorrected. The idea of targeting nominal GDP is to leave room for real growth, but damp any inflationary take-off.”
By this he means that if the nominal GDP target is 5 per cent that figure would be split between the rate of inflation and the pace of economic growth. Were a rise in the inflation rate to push the combined figure over 5 per cent the central bank would be compelled to tighten policy, and equally it would be required to loosen policy if slowing growth forced the number downwards.
Some have also suggested that shifting the mandate could help to make central bankers more accountable to the public they serve. As recent history has shown, the Bank of England’s 2 per cent inflation target can be flouted if the Monetary Policy Committee deems it likely that the economy will weaken in the near future and the rate of price increases will fall.
Unfortunately this means that the Bank has breached its mandate from Parliament consistently for the past 37 months and, as a consequence, arguably violated its pact with the British public. Scott Sumner, economics professor at Bentley University in Waltham, Massachusetts, says this problem can be avoided with an explicit NGDP target:
He says: “Arguably, the greatest advantage of targeting NGDP futures prices is not that markets can forecast better than the Bank of England, but rather as a mechanism for holding central banks accountable… Right now all the public can do is look on with dismay when nominal aggregates fluctuate wildly. Under an NGDP futures targeting regime the public would have a strong economic incentive to push monetary policy back on track during periods of instability.”
Increased accountability and predictability of policy should also help improve the effectiveness of monetary policy. If the 5 per cent nominal growth rate looks set to be missed then markets can have confidence that policy will be eased and vice versa if there is an overshoot.
In theory this would help reduce the likelihood of market panics in the event of a downturn. As Ernst & Young’s ITEM Club concluded in its Winter 2013 UK Forecast, released last week:
“[The] textbook argument for the superiority of money GDP over inflation targets seems compelling in current circumstances. Moreover, the money value of output is not just easier for the MPC to control, it is also much easier than inflation for the ONS to measure.”
The technical case against an NGDP target
Although much attention has been lavished on the Carney quote above, the Canadian central banker was keen to stress that a change in policy was far from a foregone conclusion. In fact he said:
“[The] benefits of such a regime change would have to be weighed carefully against the effectiveness of other unconventional monetary policy measures under the proven, flexible inflation-targeting framework.”
And there are plenty of current and former central bankers who remain committed to an inflation target. Former MPC member Andrew Sentance, for example, has cautioned against making any radical changes at the Bank.
“So what is the case for changing the Bank of England’s monetary policy remit? Growth has been in line with past trends, taking good times with bad. And the period of weakest growth performance has coincided with a period when the Bank has largely set asides its inflation target remit,” he said. “Employment has held up better than we might have expected. To me, this looks like a case for reinforcing the Bank of England’s inflation target remit, not changing it.”
Furthermore there are benefits to having an inflation target. With a nominal growth target there would be no preference between the balance of real GDP growth and inflation. This could have serious repercussions on inflation expectations.
“An NGDP target could make a difference but I’m not sure it would be positive for the balance between inflation and real growth,” says Azad Zangana, a European economist at Schroders. “Inflation could be running at 5 per cent and growth could be zero but you would still hit a 5 per cent NGDP target.”
Zangana says this could cause people to focus more on inflation protection than investment opportunities. To counter this central banks could set themselves inflation tolerances – as the Federal Reserve has moved towards – although this would increase the likelihood that the NGDP target would be missed.
This latter difficulty would only be exacerbated by the fact that a mandate change does not add any further tools to the central bank’s arsenal and there are growing doubts of the efficacy of existing levers.
Despite the fact that the first round of QE appeared to have had the desired effect, it has been harder to gauge the impact of further rounds. With interest rates already bumping against the zero bound, if QE is suffering from diminishing returns then hitting either an inflation or NGDP target could be equally challenging.
Questions have also been raised as to whether changing the mandate would have made a significant difference to central bank policy either prior to or in the early stages of the crisis. This is because an NGDP target relies on good quality forecasts and, as recent experience demonstrates, both growth and inflation forecasts have not been as accurate as policymakers would have hoped.
“The problem in 2009 wasn’t so much that policy was too tight but that the Bank’s GDP forecasts were too optimistic,” economist Chris Dillow wrote on his blog Stumbling and Mumbling. “For example, in August 2008 it was forecasting that real GDP would grow 0.6 per cent in the following four quarters, but in fact it dropped 3.7 per cent. Had the Bank’s forecasts been more accurate, it would have run a looser policy even with an inflation target. An NGDP target would not solve the problem that forecasts are inaccurate.”
Moreover, GDP estimates have also been subject to significant revisions which would mean having to repeatedly revise the NGDP target, as the table shows.
The problem of monetary policy primacy
Yet there are also some more fundamental problems to the idea that a central bank alone should be responsible for providing the drivers for economic growth.
Most mainstream economic models assume that the role of fiscal policy during a recession is to act as a stabilising force, increasing spending on social welfare to mitigate falling economic activity. Central banks could then use their interest rate levers to lower borrowing costs, push interest down on savings (decreasing the incentive to hoard capital) and improve growth expectations.
John Quiggin an Australian economist and a Laureate Fellow at the University of Queensland, argues that the financial crisis fundamentally challenged this model.
In a recent blog he wrote: “Clearly there was a consensus as of early 2008. The differences between “saltwater” (former New Keynesian) and “freshwater” (former New Classical/Real Business Cycle) economists had blurred to the point of invisibility. Everyone agreed that the core business of macroeconomic management should be handled by central banks using interest rate adjustments to meet inflation targets. In the background, central banks were assumed to use a Taylor rule to keep both inflation rates and the growth rate of output near their target levels.
“There was no role for active fiscal policy such as stimulus to counter recessions, but it was generally assumed that, with stable policy settings, fiscal policy would have some automatic stabilizing effects (for example, by paying out more in unemployment insurance, and taking less in taxes, during recessions)… This broad consensus was destroyed by the Global Financial Crisis and the Great Recession, but it wasn’t replaced by anything resembling a real debate.”
As Quiggin suggests, traditional policy channels proved insufficient to cope with the impact of the global financial crisis and its aftermath. Instead a combination of massive fiscal stimulus alongside a range of new monetary policy tools, including large-scale central bank asset purchases and looser inflation targets, were brought in to counter systemic threats to the financial system.
Whether these new tools have proven successful is the subject of much debate. What is increasingly apparent though is that subsequently central bankers have proven far more responsive to changing circumstances than politicians on both sides of the Atlantic.
“It is hard to imagine [the Bank] being any easier than they have been,” says Simon Ward, chief economist at Henderson Global Investors. “They have tolerated higher-than-target inflation and so clearly prioritised growth.”
Given the political gridlock in the US and government spending cuts being enacted across the European Union it is understandable that focus has been driven towards areas where meaningful policy decisions can still be achieved (i.e. the Federal Reserve and the Bank of England). Yet while central bank policy loosening (even the unorthodox variety) undoubtedly has an impact, it is being diluted by the threat of fiscal tightening hanging over developed economies.
This point could prove crucial. If the West is facing a period of persistent demand weakness with current output significantly below potential then the private sector may have little reason to invest in trying to grow their businesses, and a large incentive to hoard capital. Indeed this is what we have seen.
Slate’s Matthew Yglesias says that the best way in which to shake these reserves loose is through leaning on monetary policy measures. He writes:
He says:“That is why a real strategy for bringing corporate cash off the sidelines does not have anything to do with tax reform (though tax reform might be nice), it has to do with monetary policy. Specifically an NGDP targeting strategy or an “Evans Rule” strategy would work on both of these dimensions. That is because both the Evans Rule or a reasonable NGDP target amount to a promise that either real growth will be faster-than-expected or else inflation will be faster-than-expected or else both. That does not give you “certainty” about the future, but it gives you a rational basis for shifting assets at the margin out of low-yield high-liquidity strategies and into more aggressive ones. That more aggressive business investment posture should, in turn, produce both more real output and somewhat higher prices thus creating a credible virtuous circle.”
It is certainly the case that profitable firms must decide what to do with their excess cash. Yet when faced with existential threats, such as a eurozone collapse, or the prospect of wilful demand destruction carried out by governments they have good reason to seek insurance in “safe assets” like sovereign debt (or interest-paying central bank reserves) rather than put capital at risk.
These problems have been exacerbated by the types of cuts so far undertaken by the Coalition government. As the ITEM Club warns:
“UK business sentiment and consumer confidence are at a low ebb and will take time to recover, and the ITEM Club believes that fiscal policy has not been as helpful as it could have been to this end. The government initially shied away from large cuts in current spending and went instead for large cuts in capital spending – despite their high GDP impact – and indirect tax increases – despite their high inflation impact.”
If the UK’s recent economic performance is any guide then there should be some serious doubts over how effective those policies have been. As Jonathan Portes, director of the National Institute of Economic and Social Research, has suggested the danger with making the case for government cuts on the basis of a weakening economy is that it risks self-fulfilling pessimism even as debt markets are effectively paying governments to borrow.
That is not to say that there both the UK and the US can indefinitely avoid difficult decisions on spending to put themselves onto sustainable fiscal trajectories in the long run, including dealing with contentious issues such as healthcare and pensions. However, lumping these in with short-term efforts to reduce the deficit looks increasingly counterproductive.
Assuming that changing the central bank’s mandate alone will overcome these problems gives far too much responsibility to Carney, and too little to politicians.
So what now?
While it is impossible to predict what Carney will do once he takes over from King in June he has made it clear that he is willing to consider a number of approaches, including unorthodox ones, to deal with the UK’s economic problems. This in itself is a clever piece of expectations management from the future Bank of England Governor.
The question for most people is whether an NGDP target would genuinely help spur a recovery. Although the arguments for and against are predominantly theoretical, the Bank’s willingness to ignore its inflation target in recent years could suggest it has been following a soft NGDP-type target. If so, it is fair to say that the results have been mixed.
In fact it may well prove that the most important quote from Carney’s speech were not his musings on a nominal growth target but his reiteration of the need for a “flexible inflation-targeting framework”.
Perhaps most importantly, Meade’s original conception of a functioning policy framework involved close communication and coordination between governments and central banks.
Unfortunately, as former MPC member Adam Posen conceded in June, to date the Bank has been “too optimistic” about the ability of monetary policy to offset spending cuts. Without a change in the government’s fiscal plans a shift to NGDP targeting may make little difference in the short term.