Central banks can phase in nominal GDP targets without damaging the inflation
anchor, by Jeffrey Frankel, Vox EU: The time is right for the world’s
central banks to reconsider the framework they use in conducting monetary
policy. The US Federal Reserve and the ECB are still grappling with sustained
economic weakness, despite years of low interest rates. In Japan, Shinzō Abe,
the new prime minister from the Liberal Democratic Party (LDP), was elected on
the promise of a new, more expansionary monetary policy (Financial Times
2012). In the UK, Mark Carney, the incoming Governor of the Bank of England, is
open to new thinking.
Monetary policymakers would do well to consider a shift toward targeting
nominal GDP; Carney is evidently considering precisely this. They could phase in
such a switch in two steps, in such a way as to preserve credibility with
respect to inflation.
A number of monetary economists pointed out the robustness of nominal GDP
targeting after monetarist rules broke down in the 1980s.1
“Robustness” refers to the target’s ability to hold up in the long term under
various shocks. The context at that time was the need in advanced countries for
an explicit anchor to help bring expected inflation rates down. The status quo
regime to achieve this, during the heyday of monetarism, was a money growth
rule. Relative to the money growth rule, the advantage of nominal GDP targeting
was robustness with respect to velocity shocks in particular.
These days, both the presumptive nominal anchor and cyclical context are very
different than they were in the 1980s. The popular regime is inflation
targeting. The advantage of a nominal GDP target relative to a CPI target is
robustness, in particular, with respect to supply shocks and terms of trade
shocks. For example, a nominal GDP target for the ECB could have avoided July
2008’s mistake: the ECB responded to a spike in world oil prices by raising
interest rates to fight consumer price inflation, just as the economy was going
into recession. A nominal GDP target for the US Federal Reserve might have
avoided the mistake of excessively easy monetary policy during 2004-6, a period
when nominal GDP growth exceeded 6%.
The return of nominal GDP targeting
Why have proposals for nominal GDP targeting been revived at this particular
juncture, after two decades of obscurity? The motive, in large part, is to
deliver monetary stimulus and higher growth – needed in the US, Japan, UK and
the Eurozone – while still maintaining a credible nominal anchor.2
For a country teetering on the fence between recovery and recession, such as the
Eurozone, a target for nominal GDP that constituted a 4 or 5% increase over the
coming year would in effect supply as much monetary ease as a 4% inflation
Some economists, such as IMF Chief Economist Olivier Blanchard (2010), have
proposed responding to recent high unemployment by setting a target for expected
inflation above the traditional 2% – say, 4% – as a way of reducing real
interest rates in the presence of the “zero lower bound” on nominal interest
rates. They like to remind Fed Chairman Ben Bernanke of similar recommendations
that he made to Japan in the past.
Little support for high inflation target
Many central bankers are strongly averse to countenancing inflation rate
targets of 4%, or even 3%. They do not want to abandon the hard-won 2% number
that has succeeded in keeping inflation expectations well-anchored for so many
years. Economists can say that the upward change in the inflation target would
be made explicitly temporary, but central bankers worry that to target a higher
number even temporarily would do permanent damage to the credibility of the
This is also a reason why these same central bankers are wary of the current
proposals for nominal GDP targeting.3 Fed governors, for example,
worry that to set a target for nominal GDP growth of 5% or more in the coming
year would naturally be interpreted as setting an inflation target in excess of
2%, and thus again would damage the credibility of the anchor, permanently.
Their reluctance to give up on 2% is unlikely to change. But it doesn’t have to.
A nominal GDP target
The practical solution for overcoming these worries entails phasing in a
nominal GDP target in two steps.
One of the main communications devices currently used by the US Federal
Reserve is the Summary of Economic Projections. The governors and regional
presidents give their forecasts of real growth rate and inflation rates for each
of the next three years and for the long run – as well as for interest rates.
The press interprets these as policy statements, even if they are only labeled
My proposal is to start, in Phase I, by:
- Omitting near term projections for real growth and inflation.
Do keep the longer-run projection, and keep it at the setting where it is, 2%
– formerly 1.5-2% – for the US. But add a longer run projection for nominal GDP
growth as well, which should be around 4-4.5% to avoid any discontinuous jumps.
That number would imply a long-run real growth rate of 2-2.5%, the same as now.
Nobody could call such a move inflationary. For Japan, the targets for nominal
and real GDP growth would have to be set at lower levels, due in part to the
absence of population growth.
A few months later, in Phase II:
- Add projections for nominal GDP growth for the next three years.
These numbers should be greater than 4% – perhaps 5% in the first year,
rising to 5.5% after that – but with the long run projection unchanged at 4 or
4.5%. Much public speculation would ensue, as to how the 5.5% breaks down
between real growth and inflation. The truth is that the central bank has no
control over that – monetary policy determines the total but not the breakdown –
and thus doesn’t know what the answer is any more than anyone else does. But the
nominal GDP target would insure that either real growth will accelerate, as we
hope, or if real growth falls short, there will be an automatic decline in the
real interest rate which will push up demand. The targets for nominal GDP growth
could be chosen so as to put the level of nominal GDP on an accelerated path
back to its pre-recession trend. In the long run, when nominal GDP is back on
its path of 4-4.5%, real growth will be back at its potential, say 2.5%, and
inflation back at 1.5%-2%.
This way of phasing in nominal GDP targeting delivers the advantage of some
stimulus now, when it is needed, while satisfying central bankers’ reluctance to
abandon their cherished low inflation target.
Bean, C (1983), “Targeting Nominal Income: An Appraisal”, The Economic
Journal, 93, 806-819.
Bernanke, B, (2000), “Japanese Monetary Policy: A Case of Self-Induced
Paralysis?” Chapter 7 in Ryoichi Mikitani and Adam S. Posen (eds.) Japan’s
Financial Crisis and Its Parallels to U.S. Experience, pp. 149-166,
Institute for International Economics.
Blanchard, O, G Dell’Ariccia and P Mauro (2010), “Rethinking
Macroeconomic Policy”, IMF Staff Position Note, 12 February.
Financial Times (2012), “Monetary
policy moves to forefront in Japan”, December 17.
Frankel, J (1995), "The
Stabilizing Properties of a Nominal GNP Rule," Journal of Money, Credit
and Banking 27, 2, May, 318-334.
Frankel, J (2012), “Inflation
Targeting is Dead. Long Live Nominal GDP Targeting,” VoxEU.org, 19 June.
Feldstein, M and J Stock (1994), “The Use of a Monetary Aggregate to Target
Nominal GDP” in N Gregory Mankiw (ed.) Monetary Policy, NBER,
University of Chicago Press).
Hall, R E and N G Mankiw (1994), “Nominal Income Targeting”, in N Gregory
Mankiw, ed., Monetary Policy, (University of Chicago Press), 71-93.
Hatzius, J (2011), “The Case for a Nominal GDP Level Target,” US Economics
Analyst, issue 11/41, Goldman Sachs, October.
Krugman, P (2011), “A
Volcker Moment Indeed (Slightly Wonkish),” blog, 30 October.
Krugman, P (2012a), “Two
per cent is not enough”, The New York Times, 26 January.
Krugman, P (2012b), “Earth
to Bernanke”, The New York Times, 24 April.
McCallum, B T and E Nelson (1998), “Nominal Income Targeting in an
Open-Economy Optimizing Model,” Journal of Monetary Economics, 43(3),
Meade, J (1978), “The Meaning of Internal Balance”, The Economic Journal,
Romer, C (2011), “Dear
Ben: It’s Time for Your Volcker Moment,” The New York Times, 29
Woodford, M (2012) “Methods of Policy Accommodation at the Interest-Rate
Lower Bound,” presented at the Jackson Hole symposium, August, Federal Reserve
Bank of Kansas City.
1 James Meade (1978), followed by Bean, Hall, McCallum, West, Feldstein,
Stock, Frankel, McKibbin.
2 The new proponents show up on the left, the right, and the center of the
political spectrum: Romer (2011), Krugman (2011); on the Left; Scott Sumner (at
Money Illusion), Lars Christensen (at Market Monetarist), David Beckworth (at
Macromarket Musings) on the Right; Goldman Sachs (2011) and Woodford (2012) in
3 Central bankers have long had some other concerns as well about nominal GDP
targeting. (1) One is that the public doesn’t know the difference between
nominal GDP, real GDP and inflation. But communications clarity is not a reason
to go with a complicated function of inflation and real growth (as in the
ubiquitous Taylor rule) as opposed to the simpler nominal income target.
Furthermore, the financial markets do understand the difference. (2) Central
bankers also worry they may not be able to achieve the target. Needless to say,
the margin around the target could and should be wide, though there is no reason
why it has to be wider than the bands around the old M1 targets or the more
recent inflation targets, and there are reasons to think the width of a nominal
GDP band could be a bit less. Moreover, under current conditions, the shift in
policy need be nothing more than a commitment to keep monetary policy easy so
long as nominal GDP falls short of the target. It would thus serve a purpose
similar to the Fed’s December 12, 2012, announcement that it would keep interest
rates low so long as the unemployment rate remains above 6.5% - but it would not
suffer the imperfections of the unemployment number (particularly its inverse
relationship with the labor force participation rate and its tendency to lag
other measures of expansion).