In a few days the clock will run out on another year of disappointing economic growth in the United States and, generally speaking, in the world. It is inevitable and appropriate, then, that the year-end ritual of looking forward by looking backward will include an assessment of whether more or better policy can contribute to a pick-up in growth that failed to materialize in 2012.
To this discussion, Harvard professor Jeff Frankel brings some fresh thinking to the not-quite-fresh notion that the Fed should adopt a nominal gross domestic product (GDP) targeting approach as a replacement for existing central bank practice—described by Frankel and others as policy driven by an inflation-targeting framework. What I particularly like about Frankel’s proposal is the fact that he offers up a practical roadmap for using the Fed’s current communications tools to transition to an explicit nominal GDP targeting framework. If I were inclined to think such a move would be a good idea, I would view Frankel’s proposal with some enthusiasm. Alas, I am not yet so inclined.
As to the case for skepticism on theoretical grounds, I commend to you this excellent post by Mark Thoma at Economist’s View. But Professor Frankel suggests a case for nominal GDP targeting on practical grounds by appealing to this counterfactual:
A nominal GDP target for the US Federal Reserve might have avoided the mistake of excessively easy monetary policy during 2004-06, a period when nominal GDP growth exceeded 6 per cent.
Maybe. Average annual real GDP growth over those three years was just over 3 percent, compared to the Congressional Budget Office (CBO) estimates of potential GDP growth of just under 2.5 percent. That’s not a big difference, but more importantly the average gap between the level of real GDP and the CBO estimate of potential was just 0.3 percent of average output—essentially zero. The importance of this so-called “output gap” becomes evident if you read the Michael Woodford interview referenced in the aforementioned piece at Economist’s View. In that interview, Woodford says, “The idea was to talk about a price level, as opposed to the inflation rate, but a corrected price level target where you add to it some multiple of the real output gap.” So for him, something like this measure would be a key element of his proposed monetary policy rule.
What if, rather than some measure of nominal GDP, the 2004–06 Fed had instead been solely focused on the inflation rate? You can’t answer that question without operationalizing what it means to be “focused on the inflation rate,” but for the sake of argument let’s simply consider actual annualized PCE inflation over a two-year horizon. (In his press statement explaining the Federal Open Market Committee’s (FOMC) latest decision, Fed Chairman Ben Bernanke suggested using a one- to two-year horizon for inflation forecasting horizon to smooth through purely transitory influences on inflation that the central bank would inclined to “look through.”) Here’s the record, with the period from 2004 through 2006 highlighted:
If you really do think that there was a policy mistake over the 2004–06 period—and in particular if you believe the FOMC during that should have adopted a more restrictive policy stance—I’m hard-pressed to see what advantage is offered by focusing on nominal GDP rather than inflation alone. In fact, you could argue that that the GDP part of the nominal GDP target would have added just about nothing to the discussion.
I add the observation in the chart above to my earlier comments on an earlier Frankel call for nominal GDP targets. To summarize my concerns, the Achilles’ heel of nominal GDP targeting is that it provides a poor nominal anchor in an environment in which there is great uncertainty about the path of potential real GDP. As I noted in my earlier post, there is historical justification for that concern.
Basically, anyone puzzling through how demographics are affecting labor force participation rates, how technology is changing the dynamics of job creation, or how policy might be altering labor supply should feel some humility about where potential GDP is headed. For me, a lack of confidence in the path of real GDP takes a lot of luster out of the idea of a nominal GDP target.