In previous posts I pointed out that Australia had avoided recession for 26 years by keeping NGDP growing at a decent clip.  Some commenters suggested that it wasn’t monetary policy; rather Australia was a “lucky country” benefiting from a mining boom.  That theory made no sense, because if your economy depends on highly volatile commodity exports then you should have a more unstable business cycle than countries with large and highly diversified economies.  In any case, recent data completely blows that theory out of the water:

Stephen Kirchner directed me to a very interesting article discussing the views of Warwick McKibbin, who used to be a governor at the Reserve Bank of Australia:

Former Reserve Bank of Australia board member Warwick McKibbin says the world’s central banks should switch to a system of using official interest rates to target nominal income growth to ensure huge household and government debt burdens are unwound safely. . . .

“Inflation has been a good intermediate step because it tied down price expectations and gave people confidence that central banks wouldn’t deflate away their assets,” he will tell a major economics conference in Sydney on Wednesday.

“That’s important when you have high inflation,” as was the case in the 1970s, 1980s and early 1990s.

“But you can still have the same credibility if you do have a very explicit income target, which is really growth plus inflation,” he says.

In Australia, he suggests, that would mean the Reserve Bank would attempt to keep nominal gross domestic product growth – which is essentially a measure of how much the economy is paid for the goods and services it produces – at about 6 per cent.

Australia has a population growth rate of 1.4%, and so there is no question that Australia’s NGDP growth rate should be higher than in the US rate (pop. growth = 0.7%), and much higher than in Japan (falling population).  Nonetheless, I think 6% is a bit high, I’d recommend something closer to 5% for Australia.  On the other hand even 6% would be far better than the sort of policy enacted by the Fed, ECB and BOJ since 2008.

Professor McKibbin, from the Australian National University’s Crawford School, acknowledges that in practice the Reserve Bank already pursues an “ambiguous nominal” income growth target because the formal 2-3 per cent inflation target is only applied “over the cycle”

This supports the claim of various market monetarists, who have suggested that Australia was a covert NGDP level targeter during the Great recession.

I’ve argued that the greatest advantage of NGDP targeting for countries like Japan is that it can reduce the burden of the public debt.  McKibbin makes a similar argument:

“What will matter over coming decades will be nominal income growth because the sustainability of high public and private debt-to-income ratios will need higher nominal income growth than in the past.

Interestingly, even a 6% target would seem to call for monetary tightening right now:

According to his proposed income targeting scheme today’s Reserve Bank cash rate of 1.5 per cent is probably too low given nominal GDP rose in the first quarter by 2.3 per cent from the previous three months, and by 7.7 per cent from a year earlier. “Right now the central bank has probably got loose monetary policy by nominal income standards and you’d expect they’d be tightening policy according to this rule because nominal income growth is rising quite quickly.”

Wait, that can’t be right.  My critics say Australia was just a lucky country benefiting from a mining boom.  It can’t possibly be doing well now that mining investment is collapsing.  Or am I missing something?

The Economist describes how smart countries handle re-allocation out of declining sectors:

As the mining boom petered out, the Reserve Bank cut its benchmark “cash” rate from 4.75% in 2011 to 1.5%. The Australian dollar fell steeply (it is now worth $0.76, compared with a peak of $1.10 six years ago). The cheaper currency and lower interest rates have allowed the older and more populous states of New South Wales and Victoria to keep the economy bustling. Property developers are building more houses, farmers are exporting more food, and foreigners (both students and tourists) are paying more visits: Australia welcomed 1.2m Chinese last year, a record.

Re-allocation doesn’t cause recessions, tight money does.

In the past, I’ve argued that Australia might want to target total compensation of employees, rather than NGDP.  That’s because changes in the price of mineral exports can cause big swings in NGDP, without having much impact on the labor market.  Over the past 12 months, employee compensation in Australia rose by only 1.4%, far below the 7.7% rise in NGDP.  You don’t see those sorts of discrepancies in the US.  So maybe Australia doesn’t need tighter money.

PS.  David Beckworth has a new policy paper on NGDP and the knowledge problem facing policymakers.  As usual, David includes some nice graphics.

Love him or hate him, there’s no denying that Krugman is a brilliant economist. David Beckworth’s interview with Krugman is probably my favorite so far in the series, even though on the policy issues I tend to agree more with earlier interviewees such as Bullard.  (Interestingly, these two agreed on a number of issues, despite being far apart on the political spectrum.)

There’s no transcript, so I’ll rely on memory, and then leave a few observations after each point:

1.  When discussing his famous 1998 paper, Krugman said the hard part was determining the implication of an “expectations trap” for policymakers.

This is a very good point, and most people underestimate this problem.  Krugman himself has changed his views as to the paper’s implication, in the years since it was published.

2.  He indicated that when trying to exit a liquidity trap, you don’t need to just convince the central bankers, you also need to convince the public.

I have a “build it and they will come” attitude here.  If the central bank adopts an effective policy response, I think the public will believe it.  The real problem has been the failure of central banks to be willing to adopt “do whatever it takes” policies.

3.  He suggested that price level targeting might not be enough—you might need a higher inflation target if the equilibrium real interest rate fell to very low levels, and stayed there.

Here my view is different.  A liquidity trap should not be viewed as zero nominal interest rates, but rather the zero bound on eligible assets that the central bank has not yet purchased.  Imagine a policy of targeting the price level with CPI futures. That policy will work regardless of how low the equilibrium interest rate falls, as low as the central bank has the ability to adjust its balance sheet to base money demand.  Ditto for exchange rate targeting (i.e. Singapore). Liquidity traps are not times when fiscal policy is needed, they are times when bigger central bank balance sheets are needed.

Krugman cites Japan’s falling population.  On the one hand that might reduce Japan’s equilibrium real interest rate.  But it also reduces aggregate supply, which is inflationary.

4.  Krugman noted that elite policymakers don’t think that an inflation target of higher than 2% is responsible.

My immediate reaction was “Hmmm, where did they get that idea.”  To his credit, Krugman later joked “I may have set back policy by decades with that credibly promise to be irresponsible remark.”

5.  The first QE in the US and Europe helped to restore confidence to economies that had been destabilized by private sector financial turmoil.

My reaction is that that financial turmoil was at least partly caused by bad monetary policy, which was causing NGDP growth expectations to plummet.

6.  Krugman points out that Congress would have objected to a higher inflation target.

I think that’s right, but other options like PL targeting and NGDP targeting we at least possibilities.  More importantly, the Fed could have kept the inflation target at 2% and done far more in the realm of “concrete steppes”.

7.  Krugman’s ideal policy back in 2009 would have been enough fiscal stimulus to get inflation up to 4%, followed by standard monetary policy to stabilize the economy after that (presumably something like policy during the Great Moderation, except with a high enough inflation target to prevent hitting the zero bound.)

That might work, but if you raised the inflation target to 4%, then I doubt you’d even need fiscal stimulus.

8.  On whether 2% was a target or a ceiling, Krugman actually seemed less cynical than David (which might surprise people given their personalities).

I tend to agree with Krugman on this point, but I also believe that David has the better argument, and this is one place where Krugman struggled a bit to refute it. He talked about central bankers wanting to go back to the old days of Volcker, when they fought a heroic battle against inflation, and he also talked about the Fed as an institution having a bias toward fighting inflation.  Of course you could view those observations as supporting David’s claim about 2% being a ceiling, and I sensed that Krugman saw that as well.

9.  Krugman suggested that he had mixed feelings about NGDP targeting, worrying that it might allow too much inflation volatility.

Here again, he struggled a bit in his reply.  At one point he tried to suggest a scary counterfactual of 1% RGDP growth and 4% inflation, and then immediately seemed to realize that a few minutes earlier he had advocated 4% inflation.  In my view Krugman missed the point here.  A period of 1% RGDP trend growth is precisely when you are likely to see the sort of low equilibrium real interest rate that Krugman himself thinks calls for 4% inflation target.  Admittedly I am relying a bit on a sort of “divine coincidence” of RGDP trend growth and equilibrium real interest rates moving together, but I also think there are strong labor market reasons to prefer NGDP targeting. Krugman said something about menu costs of inflation, but surely he cares more about unemployment than menu costs, and labor market stability is almost certainly more closely correlated with NGDP than inflation. Indeed an awareness of that fact (in my view) largely explains why central banks have “flexible” inflation targets.

Like most other mainstream economists, Krugman doesn’t seem aware of all the arguments for NGDP targeting made by market monetarists, and even earlier by George Selgin.  We still have work to do.

Overall a great interview.  Krugman said, “I don’t really know” more often than one might expect from reading his NYT columns, which is to his credit.

I used to think his bashing of the GOP was exaggerated, but now it seems on target.  I say he’s finally got it right, whereas Krugman would presumably say that Trump proves that he was right all along.

I recently listened to three podcasts, involving James Bullard, Miles Kimball and Tyler Cowen.  In all three cases, I found myself agreeing with most of the ideas. Here I’ll mention a few areas of slight disagreement.

1.  David Beckworth interviewed James Bullard on monetary policy.  Most of what he said made a lot of sense, including his comment that the Fed might be more sympathetic to the NGDP targeting idea if it were starting from scratch, rather than already having invested a lot of credibility capital into inflation targeting (my words, not his.)  My only major area of disagreement was when Bullard worried that the NGDP target would have to be adjusted when the trend rate of RGDP growth changed.  In my view that’s not necessary, except perhaps for the part of RGDP growth changes that reflect changes in labor force growth.

2. Miles Kimball talks about the need for faster RGDP growth, and discusses some ideas for getting there.  He points out that we can’t get significantly faster growth from sectors that have shrunk to a small share of GDP, such as agricultural, and to some extent even manufacturing.  He suggests the big problem area is housing, which absorbs a big (and increasing) share of the consumer budget, but which is seeing virtually no productivity growth.  He focuses most of the talk on making the service sector more efficient.

It’s interesting listening to the Kimball and Cowen podcasts back to back.  In both cases you see Mormon cultural ideas lurking in the background (indeed both speakers alluded to this religion.)  Both are very idealistic, like top 2%.  Kimball suggests imposing a tax surcharge that can be avoided entirely if you donate the equivalent amount to an approved charity.  He argues that donating money makes people less cynical and more altruistic, as compared to being forced to pay taxes to a government bureaucracy that doesn’t seem interested in where you or I think the money should go.  Perhaps people would not work as hard to evade this sort of “tax.”

3.  Cowen notes that people who donate to charity tend to be happier.  He also believes that economic growth is the best way to boost living standards, even for the poor.  (Both Kimball and Cowen emphasize that “growth” should include factors like the environment.)  I’m agnostic on the happiness studies—I wonder if perhaps we’ve got causation wrong; maybe happiness causes altruism and high incomes, not vice versa.  But given that we don’t know, we should probably err on the side of assuming that at least some correlation runs from charity and growth to happiness. (Tyler has a very interesting discussion of what we should do when we don’t know for sure which theory is true.)

Cardiff Garcia did a great job in his interview of Tyler.  Much of it focused on Tyler’s new (unpublished) book, which discusses the philosophical ideas that underlie his other writings. They ended with a discussion of the NBA.  In my view, this is a golden age of basketball.  Never have there been so many great players (AD, Paul George, Chris Paul, Jimmy Butler, Isaiah Thomas, Giannis, John Wall, etc.) who are not even in the top 6 NBA players.  Some of these guys would have been borderline MVPs in previous generations.  But I do have one complaint. The NBA really needs to change one of its rules, as defense gradually evolves to make any sport less entertaining.  Here goes:

New rule:  Officials should ignore minor intentional fouls on fast breaks, where a call would clearly favor the defense.  If the intentional foul is so extreme as to physical stop the fast-breaking offensive player (such as tackling or wrapping up) the official should award (one or two) free throws plus the ball.

In other words:  Discretion, not rules!

I miss the old “showtime era” of the 1980s, when fast breaks were more common. There is something wrong with a rule where:

1.  Calling the foul helps the team that commits the foul.

2.  Calling the foul makes the game more boring.

In economic terms, calling a foul has a “cost”, as they make the game more boring. Fouls can only be justified if they have an even greater benefit to fans.  Often they do—preventing excess physicality—but not minor intentional fouls on fast breaks.

PS.  Westbrook should be the MVP.  He won 47 games with the rest of his team being worthless.  He outplayed Harden when both were on the floor in the playoffs, despite Harden’s supporting cast being far, far better.  He only lost because the Thunder were complete garbage in the 5 minutes he wasn’t on the floor each game. Obviously LeBron is the best player in the NBA, but he’s not the MVP this year.  His team is talented, and should have won more games.

I just listened to a very interesting Macro Musings podcast—with David Beckworth interviewing Tyler Cowen.  Tyler sees the Fed passivity during the last decade as part of a broader increase in risk aversion across American society, part of what he calls the rise in complacency.  I like that hypothesis, and look forward to reading his new book on my vacation next week.

I’m less convinced by his argument that this also explains the public’s obsession with low inflation, and refusal to contemplate NGDP targeting.  I would argue that the public is not opposed to NGDP targeting, indeed they’ve never even heard of the idea.  So let’s try to disentangle what Tyler had in mind in his comments on this subject:

1.  The public might prefer the specific policy of inflation targeting to the specific policy of NGDP targeting.

2.  The public might prefer the outcome (in terms of economic performance) of inflation targeting over the outcome produced by NGDP targeting.

The first interpretation is a complete nonstarter.  If you asked the average American to discuss strict inflation targeting, flexible inflation targeting, symmetric inflation targeting, asymmetric targeting, growth rate targeting, level targeting, etc., you’d produce a glazed look on their faces.  And even that understates the problem.  Most people only understand the concept of supply side inflation; they have absolutely no understanding of demand side inflation.  Hence they think inflation is bad because it lowers their real income, but that’s only true of supply side inflation.  Even worse, the Fed only controls demand side inflation, so Fed policy has no impact on the only kind of inflation the public understands.  I used to ask my class whether the cost of living had actually increased if both wages and prices rose by exactly 10%.  And over 95% always got it wrong, claiming that the cost of living had not actually increased.  (Actually, it rose by 10%.)

And even that understates the problem, because very few Americans even understand that the Fed can choose between 2% and 4% trend inflation like someone choosing between massaman curry and pad thai for their entree.  They don’t know that that is what the Fed does.  How many Americans know that the Fed’s tight money caused the Great Recession?

So I’m going to assume that what Tyler meant was that Americans would be happier with the outcome of inflation targeting as compared to the outcome of NGDP targeting.  I doubt that.  People might say they prefer 0% inflation to 2% inflation, but I doubt that they’d say they prefer America’s 2009 economy to its 2007 economy.  But the 2009 economy is what you get when you reduce inflation to 0%.  Actually, we were much closer to NGDP targeting in the period before 2007 than in the years immediately after 2007.  And yet Americans seemed much more unhappy with the post-2007 economy.  Now of course it’s entirely possible that if the Fed had kept NGDP growing at 5% after 2007, the public would have been even angrier than they were with the actual policy (a fall of 3% in NGDP between mid 2008 and mid-2009.)  But I doubt it.  I think they would have been a bit disgruntled by the stagflation, but nothing more.

Both David and Tyler believe that the Fed now views 2% inflation as a ceiling, not a symmetrical target.  I’m still not convinced; let’s look at this again in 10 years.  If it’s still a ceiling, I’ll throw in the towel.  It was clearly a symmetrical target before 2007—why would the Fed have suddenly changed?

PS.  David and Tyler also discussed the declining rate of innovation in the arts.  Here’s a quote from a different Tyler Cowen interview:

If you think about Renaissance Florence, at its peak, its population, arguably, was between 60,000 and 80,000 people. And there were surrounding areas; you could debate the number. But they had some really quite remarkable achievements that have stood the test of time and lasted, and today have very high market value. Now, in very naive theories of economics, that shouldn’t be possible. People in Renaissance Florence, they didn’t produce a refrigerator that we’re still using or a tech company that we still consult.

But there’s something different about, say, the visual arts, where that was possible, and it was done with small numbers. So there’s something about the inputs to some kinds of production we don’t understand. I would suggest if we’re trying to figure out, like what makes Silicon Valley work, actually, by studying how they did what they did in the Florentine Renaissance is highly important. You learn what are the missing inputs that make for other kinds of miracles.

That’s an interesting point–future generations will be more interested in our art than our technology.

Here’s another question to consider. In the arts, there are periods of rapid innovation (the Renaissance), followed by periods of stasis. In David’s interview, Tyler cites the rapid innovation in pop music during the 1960s, relative to the slower innovation today. Is that different from the observation that explorers no longer discover as many new lands as they did in the heyday of Portuguese and Spanish exploration?  Are we less talented at exploration, or are there simply fewer as yet undiscovered lands? Perhaps the analogy is silly, but let’s take it a step further.  The discovery of new planets, and the technology that allows us to get there, would presumably lead to another Golden Age of discovery.  Doesn’t the invention of new art forms (the novel, film, electronic music, etc.) open up vast new fields for artistic discovery? Isn’t Robert Gordon’s argument that innovation in existing fields has diminishing returns, and that we need to develop entirely new fields to supercharge innovation?  Thus we understand the physics of the non-microscopic world so well that it’s getting really hard to radically improve our houses, cars, airplanes, ships and washing machines.  The only area of rapid innovation is at the microscopic level (biotech, computer chips, etc.), which opened up only in the past 50 years or so.  Gordon doesn’t expect more such fields to open up, and thus predicts diminishing rates of innovation in the fields that we already have.  (I’m agnostic on that claim.)

Lots of people have tried to find flaws in NGDP targeting, but most of these posts are written by people who have not done their homework.  Basil Halperin is an exception.  Back in January 2015 he wrote a very long and thoughtful critique of NGDP targeting.  A commenter recently reminded me that I had planned to address his arguments.  Here’s Basil:

Remember that nominal GDP growth (in the limit) is equal to inflation plus real GDP growth. Consider a hypothetical economy where market monetarism has triumphed, and the Fed maintains a target path for NGDP growing annually at 5% (perhaps even with the help of a NGDP futures market). The economy has been humming along at 3% RGDP growth, which is the potential growth rate, and 2% inflation for (say) a decade or two. Everything is hunky dory.

But then – the potential growth rate of the economy drops to 2% due to structural (i.e., supply side) factors, and potential growth will be at this rate for the foreseeable future.

Perhaps there has been a large drop in the birth rate, shrinking the labor force. Perhaps a newly elected government has just pushed through a smorgasbord of measures that reduce the incentive to work and to invest in capital. Perhaps, most plausibly (and worrisomely!) of all, the rate of innovation has simply dropped significantly.

In this market monetarist fantasy world, the Fed maintains the 5% NGDP path. But maintaining 5% NGDP growth with potential real GDP growth at 2% means 3% steady state inflation! Not good. And we can imagine even more dramatic cases.

Actually it is good.  Market monetarists believe that inflation doesn’t matter, and that NGDP growth is “the real thing”.  Our textbooks are full of explanations of why higher and unstable inflation (or deflation) is a bad thing, but in almost every case the problem is more closely associated with high and unstable NGDP growth (or falling NGDP).  In most cases it would be entirely appropriate if trend inflation rose 1% because trend growth fell by 1%.  That’s because what you really want is stability in the labor market.  If productivity growth slows then real wage growth must also slow.  But nominal wages are sticky, so it’s easier to get the required adjustment via higher inflation (and steady nominal wage growth) as compared to slower nominal wage growth.

I said “most cases” because there is one exception to this argument.  Suppose trend growth slows because labor force growth slows.  In that case then in order to keep nominal wages growing at a steady rate, you’d want NGDP growth to slow at the same rate that labor force growth slows.  As a practical matter it would be very easy to gradually adjust the NGDP growth target for changes in labor force growth. I’d have the Fed estimate the growth rate every few years, and nudge the NGDP target path up or down slightly in response to those changes.  Yes, that introduces a tiny bit of discretion.  But when you compare it to the actual fluctuations in NGDP growth, the problem would be trivial.  I’d guess that every three years or so the expected growth rate of the labor force would be adjusted a few tenths of a percent.  Even if the Fed got it wrong, the mistake would be far to small to create a business cycle.

Say a time machine transports Scott Sumner back to 1980 Tokyo: a chance to prevent Japan’s Lost Decade! Bank of Japan officials are quickly convinced to adopt an NGDP target of 9.5%, the rationale behind this specific number being that the average real growth in the 1960s and 70s was 7.5%, plus a 2% implicit inflation target.

Thirty years later, trend real GDP in Japan is around 0.0%, by Sumner’s (offhand) estimation and I don’t doubt it. Had the BOJ maintained the 9.5% NGDP target in this alternate timeline, Japan would be seeing something like 9.5% inflation today.

Counterfactuals are hard: of course much else would have changed had the BOJ been implementing NGDPLT for over 30 years, perhaps including the trend rate of growth. But to a first approximation, the inflation rate would certainly be approaching 10%.

[Basil then discusses similar scenarios for China and France.]

Basil’s mistake here is assuming that there is a 2% inflation target.  As George Selgin showed in his book ‘Less than Zero”, deflation is appropriate when there is very fast productivity growth.  Isn’t deflation contractionary?  No, that’s reasoning from a price change.  Deflation is contractionary if caused by falling NGDP.  But if NGDP (or NGDP/person) is growing at an adequate rate, then deflation is an appropriate response to fast productivity growth.  Indeed if you kept inflation at 2% when productivity growth was high, then the labor market could overheat. (See the U.S., 1999-2000).

Let’s suppose that the Japanese decide to target NGDP growth at 3% plus or minus changes in the working age population.  In that case, the target might have been 5% in the booming 1960s, and 2% today (assuming labor force growth fell from 2% to minus 1%.  Or they might have chosen 4% per person, in which case NGDP growth would have slowed from 6% to 3%.  In the first scenario, Japan would have gone from minus 2.5% inflation to about 1%, whereas in the second scenario inflation would have risen from minus 1.5% to about 2%.  Either of those outcomes would be perfectly fine.

As an aside, I recommend that countries pick an NGDP growth target higher enough so that their interest rates are not at the zero bound.  But that’s not essential; it just saves on borrowing costs for the government.

Basil does correctly note that New Keynesian advocates of NGDP targeting don’t agree with market monetarists (or with George Selgin):

Indeed, Woodford writes in his Jackson Hole paper, “It is surely true – and not just in the special model of Eggertsson and Woodford – that if consensus could be reached about the path of potential output, it would be desirable in principle to adjust the target path for nominal GDP to account for variations over time in the growth of potential.” (p. 46-7) Miles Kimball notes the same argument: in the New Keynesian framework, an NGDP target rate should be adjusted for changes in potential.

Basil points out that this would require a structural model:

For the Fed to be able to change its NGDP target to match the changing structural growth rate of the economy, it needs a structural model that describes how the economy behaves. This is the practical issue facing NGDP targeting (level or rate). However, the quest for an accurate structural model of the macroeconomy is an impossible pipe dream: the economy is simply too complex. There is no reason to think that the Fed’s structural model could do a good job predicting technological progress. And under NGDP targeting, the Fed would be entirely dependent on that structural model.

Ironically, two of Scott Sumner’s big papers on futures market targeting are titled, “Velocity Futures Markets: Does the Fed Need a Structural Model?” with Aaron Jackson (their answer: no), and “Let a Thousand Models Bloom: The Advantages of Making the FOMC a Truly ‘Open Market’”.

In these, Sumner makes the case for tying monetary policy to a prediction market, and in this way having the Fed adopt the market consensus model of the economy as its model of the economy, instead of using an internal structural model. Since the price mechanism is, in general, extremely good at aggregating disperse information, this model would outperform anything internally developed by our friends at the Federal Reserve Board.

If the Fed had to rely on an internal structural model adjust the NGDP target to match structural shifts in potential growth, this elegance would be completely lost! But it’s more than just a loss in elegance: it’s a huge roadblock to effective monetary policymaking, since the accuracy of said model would be highly questionable.

I’ve already indicated that I don’t think the NGDP target needs to be adjusted, or if it does only in response to working age population changes, which are pretty easy to forecast.  But I’d go even further.  I’d argue that the Woodford/Eggertsson/Kimball approach is quite feasible, and would work almost as well as my preferred system.  The reason is simple; business cycles represent a far greater challenge than shifts in the trend rate of output.  Because NGDP growth is what matters for cyclical stability, it doesn’t matter if inflation is somewhat unstable at cyclical frequencies.  That’s a feature, not a bug.  And longer-term changes in trend growth tend to be pretty gradual.  In the US, trend growth was about 3% during the entire 20th century.  Since 2000, trend growth has been gradually slowing, for two reasons:

1.  The growth in the working age population is slowing.

2.  Productivity growth is also slowing.

Experts now believe the new trend is 2%, or slightly lower.  I think it’s more like 1.5%.  But I fail to see how this would add lots of discretion to the system. Imagine if the Fed targets NGDP growth at 5% throughout the entire 20th century, using my 4% to 6% NGDP futures guardrails.  No Great Depression, no Great Inflation, no Great Recession.  Then we go into the 21st century, and the Fed gradually reduces the target to 4.5%, then to 4.0%.  And let’s use the worst case, where the Fed is slow to recognize that trend growth has slowed.  So you have slightly higher than desired inflation during that recognition lag.  But also recall that only NKs like Woodfood, Eggertsson and Kimball think that’s a problem.  Market monetarists and George Selgin think inflation should vary as growth rates vary.

Who’s opinion are you going to trust?  (Don’t answer that.)

Seriously, even in the worst case, this system produces macro instability that is utterly trivial compared to what we’ve actually experienced.  Or at least if we hit our targets it’s highly successful.  And Basil is questioning the target, not the Fed’s ability to hit the target.  You would have had 117 years with only one significant alteration in the target path.  Yes, for almost any other country, the results would be far worse.  But that’s why you don’t want to adjust the NGDP target for changes in trend RGDP growth.

Further, level targeting exacerbates this entire issue. . . . For instance, say the Fed had adopted a 5% NGDP level target in 2005, which it maintained successfully in 2006 and 2007. Then, say, a massive crisis hits in 2008, and the Fed misses its target for say three years running. By 2011, it looks like the structural growth rate of the economy has also slowed. Now, agents in the economy have to wonder: is the Fed going to try to return to its 5% NGDP path? Or is it going to shift down to a 4.5% path and not go back all the way? And will that new path have as a base year 2011? Or will it be 2008?

Under level targeting there is no base drift.  So you try to come up to the previous trend line.  In 2011 you set a new 4.5% line going forward, but until you change that trend line, the existing 5% trend line still holds.  If you drop the growth path to 4.5% in 2011, then by 2013 the target for NGDP will be 1% less than people would have expected in 2008, and by 2015 it will be 2% less.  In fact, NGDP was more like 10% less than people expected.  So even if a gradually adjusting path is not ideal, it’s a compromise worth making to satisfy the NKs who are far more influential than I am, but have yet to read Less Than Zero.  (George may not agree with the compromise, he’s less wimpy than I am.)

Before I close this out, let me anticipate four possible responses.

1. NGDP variability is more important than inflation variability

Nick Rowe makes this argument here and Sumner also does sort of here. Ultimately, I think this is a good point, because of the problem of incomplete financial markets described by Koenig (2013) and Sheedy (2014): debt is priced in fixed nominal terms, and thus ability to repay is dependent on nominal incomes.

Nevertheless, just because NGDP targeting has other good things going for it does not resolve the fact that if the potential growth rate changes, the long run inflation rate would be higher. This is welfare-reducing for all the standard reasons.

The “standard reasons” are wrong.  The biggest cost of inflation, by far, is excess taxation of capital income.  That’s better proxied by NGDP growth than inflation. Things like “menu costs” are essentially unrelated to inflation as measured by the government.  The PCE doesn’t measure the average amount that the price of “stuff” changes; it measures the average amount by which the price of “quality-adjusted stuff” changes.  Hedonics.  If the government were serious about targeting inflation, they’d need to come up with an inflation measure that actually matches the supposed welfare costs of inflation in the textbooks.  We don’t have that.  We have nonsense like “rental equivalent”. The standard welfare costs also ignore the massive costs of nominal wage stickiness.  And Basil mentions the incomplete financial markets problem.  Please, can macroeconomists stop talking about inflation, and use NGDP growth as their nominal indicator?  It would make life much simpler.

2. Target NGDP per capita instead!

You might argue that if the most significant reason that the structural growth rate could fluctuate is changing population growth, then the Fed should just target NGDP per capita. Indeed, Scott Sumner has often mentioned that he actually would prefer an NGDP per capita target. To be frank, I think this is an even worse idea! This would require the Fed to have a long term structural model of demographics, which is just a terrible prospect to imagine.

Actually, it’s pretty easy to predict changes in working age population, because we know how many 64 year olds will turn 65, and we know how many 17 year olds will turn 18.  And immigration doesn’t vary much from year to year.  The Fed doesn’t need long range forecasts; three years out would be plenty.  As long as the market understands that the NGDP target path will be gradually adjusted for population growth, they can form their own forecasts when making decisions like buying 30-year bonds.

I want to support NGDPLT: it is probably superior to price level or inflation targeting anyway, because of the incomplete markets issue. But unless there is a solution to this critique that I am missing, I am not sure that NGDP targeting is a sustainable policy for the long term, let alone the end of monetary history.

I still think that NGDPLT, combined with guardrails is the end of macroeconomics as we know it.  All that would be left is discussions of supply-side policies to boost long-term growth. The freshman econ sequence could be reduced to one semester. Or better yet a full year, with a more in depth discussion of micro.

PS.  In this new Econlog post I make some forecasts.