Getting Nominal Income Targeting Wrong

Just a short note this time. (Also see Scott Sumner on this.)

Excerpted from a recent St. Louis Fed Note:

Getting policymakers to agree on a specific rule of this form would seem relatively easy because GDP is well defined; there would be no debate about the variables as there would be with the Taylor rule. Moreover, the range of disagreement aboutgdpT also seems relatively small. The FOMC has already agreed on a 2 percent inflation objective, and there appears to be a consensus that potential output growth is probably in the range of 2.5 to 3.5 percent. The disagreement about nominal GDP target would be relatively narrow, in a range from about 4.5 percent to 5.5 percent.

So what prevents the Fed and other central banks from adopting nominal GDP targeting? Again, there are a number of reasons, but an important and sufficient reason is that nominal GDP targeting requires policymakers to be indifferent about the composition of nominal GDP growth between inflation and the growth of real output, and, in general, they are not. For example, let’s assume the target is 5 percent and nominal GDP is growing at 6 percent. Would policymakers react the same if the composition was 1 percent inflation and 5 percent real growth, or 5 percent inflation and 1 percent real growth? It seems unlikely. In addition, nominal GDP targeting suffers from the other considerations that prevent policymakers from adopting policy rules. For example, policymakers’ response to the alternative situations would depend on current labor and financial market conditions and activity; the composition of GDP, especially between consumption and investment; global economic conditions; and so on. In short, adopting a nominal GDP target is unlikely for many of the same reasons policymakers are unlikely to adopt a traditional Taylor rule—or indeed, any specific policy rule. The economy is too complex to be summarized by a single rule. Economies are constantly changing in ways difficult to explain after the fact and nearly impossible to predict. Consequently, policymakers seem destined to rely on discretion rather than rules.

 

Most of the piece is a good discussion of “rules vs. discretion” in monetary policy. That’s something I’m not going to get into right now. I was, however, a little surprised to see economists at the Fed mistake nominal income targeting for an indifference between inflation and growth of real output.

This is rather absurd claim because the (well argued, if disagreeable) thesis of the article is that changing dynamics of the economy undermines the efficacy of rules relative to discretion. But for policymakers to be indifferent between inflation and real output under a nominal income target, the economy must be perfectly static. An economist is indifferent between the two if and only if he believes that the rate of inflation will be constant, and the rate of real growth will be constant. In effect, he must ignore completely the possibility of severe demand shocks. But the possibility of severe demand shocks was the whole point said policymakers opted for discretion over rules. Being indifferent between inflation and output at a given point in time is completely different from being indifferent between inflation and output.

In reality, inflation changes relative to real growth all the time. The whole idea behind a nominal income target is its flexibility to these changing conditions allowing policymakers the ability to have different preferences for inflation and output given different economic dynamics. More importantly, individuals are – at some point – always indifferent between two quantities, given a certain level of each.

Ultimately, nominal GDP targeting is prone to structural changes. Lucky for the Fed, it’s their job to deal with aggregate demand.