New Man, New Mandate

Evan Soltas is right, the United Kingdom needs to adopt a nominal income target, and Mark Carney is the man for this job. This is an idea that caught the blogosphere by fire, and has enlisted hints of support from Carney himself. Maybe most importantly, an NGDP target has deep support from across the political spectrum. Everyone sees it as a way to increase immediate employment. Conservatives argue that if the central bank is targeting aggregate demand, all other macroeconomic factors become classical in nature, shifting the priority onto supply-side growth. Liberals see higher inflation during deep recession as a way of easing the burden on debtors and reducing hysteresis by increasing the opportunity cost of leaving the labor force.

Before we further the case for a NGDP target, it’s important to consider the elegance of inflation targeting, a regime existent in the United Kingdom in its current form since 2003. Unlike many other potential targets (like monetary base) once the central bank anchors inflationary expectations at the target, its job becomes a self-fulfilling prophecy. The logic is simple, if I expect 2% annualized inflation I will sign a contract that increases my wage rate accordingly. But my wages are my employer’s inflation, which will be reflected in higher price levels across the nation. More importantly, nominal income is a measurable – and publicly understandable – figure unlike monetary base, inflation, or even real income. They call it the “money illusion” for a reason.

Without a futures market (which has many criticisms of its own), an NGDP target is unlikely to be so simple and beautiful. However, it may be one of the only ways for monetary policy to gain traction at the zero lower bound. Paul Krugman, now famously, argued that successful monetary policy today must “credibly promise to be irresponsible” tomorrow. An NGDP level target will convince the market that inflation will only fall after income is on its previous trend, or full employment. Granted, it is unlikely that during roaring booms or deep recessions, contract formation will be as simple as with inflation targeting.

So far, Carney’s one objection to an NGDP target does not hold water: “As potential real growth changes over time, either the nominal target will have to change or else it will force an arbitrary change in inflation in the opposite direction”. Evan notes that this is a “small price to pay”, but I don’t see it as a “price” at all. Changes in potential growth reflect only supply-side movements and, hence, Carney’s statement would imply that the current inflation targeting regime is robust during supply shocks.

But it’s not. Consider a central bank targeting 2% inflation in a country that’s going through a shale gas revolution. Prices levels are naturally bound to fall as energy is a critical component of pretty much all output. However, if the central bank is to meet its mandate, it must artificially inflate the economy. The consequences from a negative supply shock are even worse. If the OPEC agrees to an oil embargo, a pre-shale United States faces risk of recession. Making matters worse, because general price levels are increasing, the central bank must deliberately deflate the economy in a recession.

In both cases, at least a nominal GDP target would allow the supply-side inflation to compensate for deceleration in growth rates. Carney is right that over time current proposals of approximately 5% NGDP growth might be suboptimal. But even, or perhaps especially, in a supply-shock NGDP trumps inflation.

It is overwhelmingly clear that rich world economies need more inflation. But arguments to this effect, especially from a central banker, are not popular. Arguing for more income, however, makes intuitive sense and should hold broad appeal from the general public. Of course, the latter implies the former as my wages are your inflation, but it’s just a question of semantics…

Now is the time, if any, for Carney to strike a bold new mandate. Inflation expectations in Britain are already dislodged. Indeed, with poor productivity growth, the United Kingdom is undergoing a negative supply shock with the worst system thereof. It’s about time for the country to try something bold. Something fresh.