Opinion: The case for NGDP targeting (1)

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.

* Theo Clifford is an aspiring student and blogs at economicsondemand.com.

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  • Great article.

    I concur and have been interested in NGDP targeting for some time – it’s at least worth experimentation. Current monetary policy is ineffective by almost anyone’s standard. It should also appeal to people who are broadly pro-market and people who are concerned about money being too tight (often not the same people).

    I feel that it reduces and disperses the power of an unaccountable central bank, and while it may be inflationary to an extent, it doesn’t distort relative prices in the same way that current targeting does. Anyone who’s similarly interested should follow anything by Scott Sumner and Lars Christensen, especially http://marketmonetarist.com/.

  • Richard Dean 22nd Feb '13 - 3:07pm

    Maybe, but there’s a lot of “might have”s. Is this an “any port in a storm” response? Or some spin to give the impression that economists have the answer, when in fact they don’t. Is it the economist’s version of the mad scientist wanting to do an experiment, but with the whole economy?

    Can it be true that, in the 1970’s the ” worst of stagflation might have been prevented”. How can we know? And if so, why didn’t the economists learn the lesson then? Can it be true that “In 2008, … the Bank … might have prevented the banking crisis from becoming systemic”. But some analysts seem to suggest that

    > sub-prime mortgages, together with
    > the ability of financial markets to package them into saleable objects so that losses could be passed on,
    > the idiocy and greed of some prominent bankers, exemplified by RBS and too-big-to-fail, and Lehman
    > the multiplier effect, by which a loss here gets translated into bugger losses there and then a credit crash

    was so large that no central bank would have been able to control the consequent fall in demand. How “might” NGDP targeting help households pay back their debts, or countries for that matter?

  • Richard Dean 22nd Feb '13 - 3:08pm

    bigger !

  • Theo Clifford 22nd Feb '13 - 3:56pm


    Your concern is a pretty common one. The ‘commonsense’ view of the recession is that it was caused by financial excess and that, as a result, there was nothing that the Bank of England could do about it . But if you’re arguing that the crisis was inevitable, you’re arguing either that the Bank could not have kept nominal spending on target, or that the crisis would have been just as bad even if they had.

    A lot of people think that the Bank of England’s hands were tied, that they were ‘out of ammo’ having reduced interest rates to zero and therefore could have done nothing to ease monetary policy and so increase nominal spending. This implies, however, that a central bank could not debase its own fiat currency, and that even if the Bank were to buy up all of the assets in Britain, and start in on foreign ones, it would not create any inflation. I doubt you would agree with this. Given that there is some monetary policy action that could succeed in creating inflation and NGDP growth, the problem is not one of inability to inflate but one of degree – the Bank has not done *enough* QE and other unconventional policies.

    So it’s clear that the Bank could have kept nominal spending growing at around its 5% long-term trend growth rate throughout 2008 and 2009. The question then is – what would have happened if they had? Certainly, there were problems in the economy. The housing bubble was going to burst. Some banks, like Northern Rock, had dramatically overstretched themselves. The collapse in nominal spending, however, made the problem much worse. If aggregate income continued to grow at 5%, there would have been fewer defaults and foreclosures. Consumers and businesses would not have lost confidence. There would have been some rise in unemployment as workers were reallocated out of bubble industries like construction, but nothing like the rise we have seen. There probably would have been a few years of subpar growth and above-average inflation, for this reason. Some banks would have failed. But the problems would not have become systemic. Nationalisations and bailouts would not have been necessary. The crisis would not have been allowed to become worse than the Great Depression.

    Are you really arguing that, if nominal spending had remained at trend, and so was 15% higher than it is today, that we would still be 3% below our peak levels of output, and that the banking crisis would have been just as bad.

    How do we know that the 1970s stagflation would have been prevented had economists had the right prescription? During the 1970s, economists in America and the UK thought that inflation was caused by too much union bargaining power, or by the oil crisis – two factors which were restricting aggregate supply and so driving up prices. Paul Samuelson, a Nobel Prize-winning economist, suggested that inflation was nothing to do with the money supply, and that tighter money would be like ‘putting a tourniquet around the patient’s neck to check his bleeding chin’. After all, interest rates were high – so money must have been tight, right? Eventually economists they realised that inflation was in fact accelerating due to too-loose monetary policy. If they had been looking at the increasing growth of NGDP during the 1970s, they would have known that the problem was too much demand, not supply shocks. Once economists did realise what the problem was, lo and behold, it was fixed. Paul Volcker was appointed chairman of the Federal Reserve, and was able to quickly bring down inflation there to 4%, at the cost of a recession. A similar monetary tightening happened under Thatcher, and inflation was brought down here, too – albeit more slowly.

    So I have great faith in the Bank of England not to cause runaway inflation or terrible depressions. They just have to keep NGDP growing at a steady rate, which shouldn’t be that hard – if they choose to do it.

  • Richard Dean 22nd Feb '13 - 4:36pm

    There are a lot of “would have’s in your response, Theo. How can anyone possibly know? Is this the theoretical economist at work? Looking for an experiment? One of the important conclusions from the crisis has been that the real economy performs in ways that economists don’t understand and aren’t taught (see Howard Davies’s book, The Financial Crisis – Who is to Blame?, Chapter 32, The Death of Economics)

    A “systemic” problem is one that results from the way the system is designed, isn’t it, rather than the way it is operated? One view is that the systemic problem consists of the existence of the connected sequence of causes that I identified – the ability of the system to allow fraud to be launched for political purposes, maintained and transferred for economic ones, and crashed somewhere else when it gets too big. NGDP targeting won’t change this, will it?

  • All this discussion seems to be based on the idea that we can somehow go back to the “Goldilocks” economy (i.e. not too hot and not too cold), whereas I believe we are so far from that position that an interest rate tweak here or there at the right moment will not have a major impact. The problem is that whatever the bank does on the monetary side and the government does in terms of fiscal policy, there are much larger forces at work on the UK economy and the crisis is much larger than either of these two policy levers.

    The core problems in the past two years have been that oil output has been slumping, our exports to the Eurozone have gone into freefall, our economy is weaning itself painfully off financial services as a source of earnings, oil and other commodity prices remain high and our households are massively in debt. Whatever is happening in the real economy almost always trumps the efforts of the policy makers, be they those at the Treasury or the Bank of England.

    And even if the Bank can control it in the way hypothesised, the trouble with NGDP is that it doesn’t specify any split between inflation and output. You can have 7% NGDP growth which is composed of 9% inflation and an output contraction of -2% , yet presumably, given that this is above 5%, the policy prescription would be to raise interest rates in the middle of a recession because NGDP is growing too fast.

    That is the problem with simple decision rules in economics: reality is never that simple. This fetishisation of NGDP targeting as the solution to our monetary worries reminds me of the early stages of the Friedmanite monetarist dogma: all very well until it collided with reality.

  • Take your point but if the Bank has a mandate to target growth then what was the Government doing?

    Personally, I think there is also a school of thought that the Bank should not be in this mess if they showed a willingness to prick asset bubbles. However, the Bank in 1997 is not the Bank now which has useful tools given to the FPC.

    The talk about NGDP targetting sounds to me a lot like the MPC’s role needs to be reconsidered. I’m not so sure about that. Carney’s Bank will have three major challenges to contend with
    A) figuring out a credible exit from QE
    B) weaning banks off liqudity support
    C) restoring price stability which is proving the real killer of household spending

    Finally, you should consider carefully your target. GDP statistics are prone to revision. Price deflators need to be reviewed. Data is incomplete at the time. Final GDP stats are nearly always backward looking. Even the Bank relies on agents in each region as a check on macro data. Its almost impossible to forecast correctly. Why is that advantageous over a credible inflation target that everyone has a feel for and can be quickly measured?

  • RC, you’re right in that there’s no “magic wand” to fix the economy. There are real problems that need to be fixed, and this will take time. The recent recession has been so bad for Britain because the three things we could count on during the 99-2007 period were a boom in financial services, continual increases in government spending and continuing revenues from North Sea oil. All three are now gone; financial services may recover, but this can bring its own problems. Government spending could increase, but only at the cost of higher taxes which hurt growth in the private sector, so it’s unlikely to be a major contributor to overall growth. North Sea oil isn’t coming back, even if we fracked the whole of Lancashire.

    Given these assumptions, and the fact that there’s not a massive amount we can do about them directly, we need to ensure that overall economic management is as good as it can be, and is favourable to growth. The reason NGDP targeting is being talked about at all is that inflation targeting no longer seems optimal in a situation where inflation isn’t actually telling us much about the health of the economy. Most of our inflation is coming from rises in energy prices, which we can’t control, rises in food prices which is a global phenomenon, and a rise in administered prices (rail fares, tuition fees, etc.). The actual level of inflation in the private economy is still quite low, which is consistent with continuing above-trend unemployment and stagnant wage growth.

    The real purpose of inflation targeting is not to hit the magic 2% target because 2% is a particularly good number, it’s to ensure that inflation expectations are limited; to ensure that people can’t imagine inflation being 10% next year, and 20% after that, and then 50% and so on until we’re all paying for things with 100,000 pound notes. As a result, people won’t need to ask for 20% wage increases which would make the whole thing a self-fulfilling prophecy as companies raise their prices 20% to afford them, and so on. The wage data* shows absolutely no such upward pressures at the moment, yet headline inflation is apparently above target, leading for people to call for tighter policy. An NGDP targeting approach would be an imperfect-but-better** way of recognising the fact that the only inflation we can control is the inflation that comes from overheating in the economy. Right now we have prices that are going up due to worldwide factors, without the upside of growth that would help us reduce our debts.

    * The usefulness wage data is about to get a *lot* better. From April HMRC will be requiring companies to file PAYE data in real time – that is, on or before the date that they actually make salary payments. I wouldn’t be surprised if this takes over as a major measurement of economic health, in place of the often-revised GDP and inflation figures we get now.

    ** It might actually make more sense to target nominal wages. And we’ll shortly have just the statistics we need to do exactly that.

  • NGDP is the new fetish, because inflation targeting is not working as expected. But then inflation, (RPI or CPI), has always been a very crude measure even accommodating the fact that its basket of goods have ‘weightings’. When an economy is coasting along nicely, the inflation figures are just taken ‘as is’. But when recession bites, inflation seems to morph into something called biflation, (a mix of inflation and deflation). Food, fuel, heating -UP. Ford Mondeo’s, DVD players, iToys – DOWN
    And therein lies the problem. I’ve dragged out just a few of the more extreme items from the ‘basket of goods’. YES! they are weighted. But imagine yourself as two people. Cast your eye over the list as someone earning £100,000 per year, and as someone on minimum wage (or less!)
    Item (504)-Dating Agency Fees
    (496)-Stockbroker Fees
    (458)-Full Leg Wax
    (401)-Private School Fees
    (378)-Golf Green Fees
    (377)-Gym Membership
    (353)-Livery Charges
    (307)-Euro Tunnel Fares
    (271)-Nanny Fees
    (269)-Gardeners Fees
    Are these items important to you? And by what weighting?
    Surely, instead of this new found desire to dabble with NGDP targeting, would it not be a better exercise to take a fresh look at the methods of inflation measuring, with a weighting process that has a closer link to the strata of (say), Maslow’s Hierarchy of Needs?

  • Theo Clifford 23rd Feb '13 - 4:02pm

    I think there’s a big temptation when a crisis like this comes around say, well, what is the failure of economics that caused the crisis? Why didn’t you see it coming? Yes, it is possible that economic theory has no power to predict anything or to recommend policy, and is fundamentally useless, and all economists have been wasting their life on theoretical models that have nothing to do with what really goes on in the outside world.
    But I don’t think that the financial crisis presents a serious problem for economics. If in 2005 you’d told an economist what was going to happen to nominal spending over the last five years, they would have said that the result would be a financial crisis, rising unemployment, big government deficits, and all the other things that actually happened. The saddest thing about this crisis is that we have the tools and the knowledge to fight back, but for some reason we’re unwilling to use them.
    At the time, the Great Depression was viewed as a really serious systemic problem – it showed there was something wrong with capitalism, or with finance, that had made the crash happen. It was excessive speculation, or overproduction, or some terrible structural problem with the economy that could never be reversed. Nowadays, of course, economists almost universally agree that the Great Depression was a monetary phenomenon, which was alleviated by monetary remedies, and I expect the same consensus to emerge about the current catastrophe.
    I think the key idea here is that monetary policy should be ‘neutral’ – it should allow changes in the real economy to take place. There are demand-side problems in the economy, which are caused by a lack of nominal spending (i.e. aggregate demand). And there are supply-side problems. The beauty of NGDP targeting is that it lets you deal with the demand side of the economy without having to consider the supply side. If NGDP is growing at trend, you know your problems are supply-side, and monetary policy has done its job. If NGDP is growing below trend, you know you have insufficient demand, as well as any supply-side issues you may be experiencing. If NGDP is accelerating above trend, like in the 1970s, you know that – on top of any supply-side problems, like the oil crisis – you also have too much demand. NGDP targeting helps the Bank isolate and deal with the problems it can fix, and avoid worsening those it can’t.
    Yes, there was a need in 2008 for a reduction in the size of the financial services sector. Yes, North Sea oil output was going to decline. Yes, household deleveraging was necessary. Yes, in the long term, some tax rises and spending cuts are necessary. But all of these things could have been accomplished far more easily against a backdrop of 5% growth in nominal spending throughout the period, which the Bank could easily have delivered. Monetary policy can’t ‘fix’ problems in the real economy, but bad monetary policy can certainly make them worse – and I’d argue that’s exactly what’s been going on these past few years.
    Nominal GDP is aggregate income, so it has a lot of similarities with a nominal wage target and shares the same benefits. I think nominal GDP is an easier way to conceptualise the issue, and much more likely to be implemented – but there is definitely a case that targeting nominal wages might be marginally better in some ways. Overall, I don’t think there is that much difference between targeting NGDP and targeting nominal wages.
    It’s not even clear that the Bank can do anything about asset price bubbles. Obviously, monetary policy is neutral in the long-term, so it cannot affect the price of houses relative to the price of bagels in the medium term. I think monetary policy is a risky and blunt instrument to use to restrain asset price bubbles; to the extent that financial excess is a problem, regulation is the way to go – and yes, the Bank has now been given regulatory powers, which it can and should use to ensure that the real and genuine problems we had leading up to the crisis don’t happen again.
    I did address the revisions point in the original post. Yes, data revisions are a problem to some extent, but monetary policy should be forward-looking, not backward-looking – you can look at a range of variables to estimate where nominal GDP is now and what must be done to ensure it remains on trend in the medium term. And as I pointed out earlier, inflation is more difficult to measure due to the various different indices, all of which have their own inherent problems and distortions. Nominal spending is much clearer and easier to measure, even if the data is subject to revision. And the nominal wage data that Rob drew attention to would be very helpful as well. This is also why many prominent market monetarists stress the usefulness of an NGDP futures contract, which would let policymakers see market expectations for NGDP rather than having to infer them from breakevens, asset price movements, bond yields and so on.

  • Richard Dean 23rd Feb '13 - 5:21pm

    This is what Howard Davies wrote that Nobel Prizewinner Paul Krugman wrote in krugman.blogs.nytimes.com , 27 January 2009:

    “… few economists saw our current crisis coming, but this predictive failure was the least of the field’s problems. More important was the profession’s blindness to the catastrophic failures in a market economy …. economists … mistook beauty, clad in impressive mathematics, for truth… they turned a blind eye …”

    If this diagnosis was true then, is there any evidence that economists have changed?

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