McCallum on NGDP targeting

This is from a recent paper on NGDP targeting by Bennett McCallum:

I find it plausible that movements in nominal spending growth would be more closely and reliably related to central bank policy actions—primarily open market sales and purchases—than would movements in inflation and output separately.  If so, then the central bank that targets nominal GDP would not have to rely upon its models of the way in which nominal and real variables are related, that is, its model of the “Phillips curve” relationship.  That is a significant advantage, because the Phillips curve relationship is the component of quantitative (econometric) macroeconomic models for which professional understanding and agreement is, by far, the weakest.  Thus, if the central bank can manage nominal spending growth in a manner that does not involve conceptually the Phillips curve, it can conduct policy without use of that elusive relationship.  By contrast, if it focuses on inflation and real GDP separately, or on inflation alone, it cannot possibly avoid its use.

The point of view expressed in the preceding discussion is somewhat reminiscent of Milton Friedman’s approach to price-level determination, in which he famously depicts the central bank as choosing the supply of money in nominal terms while the private sector is choosing the quantity of money demanded in real terms.  The interaction of these choices then determines the price level—see Friedman (1987, pp. 3-4).  In the present application, the central bank determines the amount of spending in nominal terms, with the private sector’s behavior determining how much of any change in spending will be in terms of (real) output changes and how much will be in (nominal) price level changes.

I like the analogy with nominal money supply and real money demand, which I’ve always seen as the core of monetary economics.  Indeed my biggest beef with Keynesians is that they don’t see Friedman’s example as the core of monetary economics.  I also like the pragmatism in McCallum’s approach.  We really don’t have good Phillips Curve models.  I think this is partly because our data is worse than many assume, and is less closely related to the theoretically appropriate concepts than many macroeconomists assume.  For instance, one reason why deflation is bad is because it’s less profitable to produce output when prices fall (if wages are sticky.)  In that context it’s interesting that official CPI figures show housing prices up 7.5% over the past 5 years, and the Case-Shiller index shows housing prices down 32% over the past 5 years.  Which provides a better estimate of the incentive to construct new houses?  Which is the inflation number used in actual economic studies by real world macroeconomists?  It’s also much easier to measure the nominal output of the health care industry, the consulting industry, or the PC industry, than to separately measure the prices and outputs of those two industries.   And even if we had accurate data, the Phillips Curve would be highly unstable due to things like the recent extension of unemployment insurance from 26 weeks to 99 weeks.  But the data problems make it even worse.

Here McCallum expresses skepticism about level targeting:

From the foregoing it can be seen that one issue that arises in discussions of nominal GDP targeting is whether the targets should be expressed in terms of “level” or “growth-rate” measures.  For an example of the distinction, suppose that the chosen rate of growth of nominal GDP is 4.5% per year.  Suppose that in some year, however, the central bank misses that target by a full percentage point on the high side, yielding 5.5% growth consisting of (for example) 3.0 percent inflation and 2.5% real growth.  Should the central bank strive for the usual 4.5% growth in nominal GDP again in the following year?  Or should it decrease its growth target to 4.0%, aiming thereby to be back at the original path for the nominal GDP level at the end of the next year?  In other words, should the nominal GDP targets be set in terms of growth rates or growing levels?  In the latter case, the disadvantage will be that policy that decreases nominal growth below its usual target value may be excessively restrictive, whereas the former case leaves open the possibility of cumulative misses in the same direction for a number of periods, i.e., it permits “base drift” away from the intended path.  My position on this issue has been that keeping with the target growth rates will, if they are on average equal to the correct value over time, be unlikely to permit much departure from the planned path and so should probably be preferred.  This is not at all a universal point of view, however, among nominal GDP supporters.

In this recent post I explained one advantage of level targeting; the fact that it leads market participants to assist monetary policymakers.  Perhaps I’ve been overly influenced by the 2008 period, when the advantages of level targeting seem relatively large.  I would also point to Michael Woodford’s work on liquidity traps.  Woodford argues that level targeting is especially important when a central bank hits the zero bound (as he is even more skeptical about QE than I am.)  McCallum may be right that when the central bank is doing its job, growth rate targeting is as good as or even better than level targeting.  By “doing its job,” I mean targeting the forecast.  But given the spotty track record of real world central banks, it seems to me that level targeting has a great advantage over growth rate targeting, the ability to prevent very large and costly errors.  It seems inconceivable to me that NGDP would have fallen 9% below trend between mid-2008 and mid-2009, if markets had known that the Fed was engaging in level targeting of NGDP and would soon return the economy to the trend line.

PS.  In my previous post I probably created the impression that I entirely agree with Romer’s post.  Those who view me as an inflationist may be surprised to learn that I actually think her recommendation is a bit too expansionary.  In 2009 I favored going back to the old (pre-2008) trend line.  I still think that policy would be better than the status quo.  But any dating of a trend line is arbitrary unless the Fed has set an explicit target.  As time goes by more and more debt and wage contracts have been set based on post-2008 expectations.  So at this late date it might be more prudent to only go part way back.

And in a sense this discussion is purely academic.  My fear is that the Fed will do too little, not too much.  My recent discussion of aiming for 6% or 7% growth for a couple years, and 5% thereafter, is actually far more conservative than the Romer proposal, but also represents the outer limits of what the Fed would be willing to do.  More likely they’d just shoot for 5%, with no catchup at all.  The same discussion occurred during the Great Depression, when some advocated going half way back to pre-Depression prices, and others advocated going all the way back.  They only went half way back, but even that would have been enough for a quick recovery if the NIRA hadn’t raised nominal wages by over 20% in the late summer of 1933.

PPS.  David Beckworth also comments on McCallum’s paper.

PPPS.  Lars Christensen also comments on McCallum.


Tags:

 
 
 

20 Responses to “McCallum on NGDP targeting”

  1. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    30. October 2011 at 09:37

    This from McCallum:

    ‘…should the nominal GDP targets be set in terms of growth rates or growing levels? In the latter case, the disadvantage will be that policy that decreases nominal growth below its usual target value may be excessively restrictive, whereas the former case leaves open the possibility of cumulative misses in the same direction for a number of periods, i.e., it permits “base drift” away from the intended path.’

    Is, I think, what makes me a little uneasy about your proposals, Scott. Especially with the current Fed balance sheet.

  2. Gravatar of marcus nunes marcus nunes
    30. October 2011 at 11:02

    Scott
    I did a post on Christy Romer´s “conversion”. Why is it that well known and well healed researchers/academics (and I don´t believe you fall in that category) only say, and try to get the “policy executives” to do what they think is right once they are “outside the loop”? Maybe that´s why many, like McCallum, never tried to get into “the loop”.
    http://thefaintofheart.wordpress.com/2011/10/30/the-romer-%E2%80%9Cconversion%E2%80%9D-and-suggestion-of-a-volcker-moment/

  3. Gravatar of Becky Hargrove Becky Hargrove
    30. October 2011 at 11:11

    Level targeting seems to equal the automatic computerized flying system in the airline pilot’s control panel. Growth targeting then would equal the pilot who still knows how to fly, especially when the automatic controls go down. A lot of people want both of those things.

  4. Gravatar of Bennett McCallum – grandfather of Market Monetarism « The Market Monetarist Bennett McCallum – grandfather of Market Monetarism « The Market Monetarist
    30. October 2011 at 11:39

    [...] 3: Scott Sumner also has an comment on McCallum’s [...]

  5. Gravatar of Bill Woolsey Bill Woolsey
    30. October 2011 at 12:08

    Scott:

    I think both you and McCollum are too focused on growth rates. In my view, the reason changes in growth paths are disruptive is that they shift the economy away from the expected growth path. Getting back to the growth path isn’t disruptive.

    Suppose the target growth path is 3% and potential output is growing 3%. An error results in nominal GDP growing 4%. Suppose the result is that the price level rises .4% and output risea 3.6%. Real output is now .6% above potential. Fortunately, it is growing (by assumption,) and next year it is will 3% higher. But that isn’t 3% higher than current real GDP. It is approximately 2.4% higher current real GDP.

    Now, if we wanted to leave the price level at .4% higher, nominal GDP would need to increase by approximately 2.4%. This would match the increase in real GDP as GDP returns to potential with the price level remaining the same, .4% higher higher than its initial level.

    If, instead, nominal GDP grows 3% from its new level, then real GDP would need to grow 2.4% to return to potential, and the price level would need to grow another .6%.

    Now, if we imagine that some kind of menu costs had to be overcome to get the initial 4% increase in the price level, then retuning nominal GDP back to target (growing 2%, more or less) then some prices or other must drop .4% if real output is going rise 2.4% back to potential. Maybe the menu costs would need to be suffered twice. Or some other firms must suffer them.

    But surely, what has really happened is that some particular markets had exceptionally high demand that will simply be reversed. And further, those markets with quite flexible prices respond with higher prices, and they will similary have flexible prices.

    Think about the stable price level approach. People have expecations about the price level for decades. All the sticky prices, the contracts, the wages, are based upon these expectations. Spending rises or falls and pushes the most flexible prices away from their equilibrium values. Why would returning spending to trend and those flexibly priced goods back to their initial values be disequilbrating?

    But the growth rate is different from 3%. Isn’t everyone adjusted to a 3% growth rate? Won’t a 2% growth rate (or 4% to reverse slower growth) cause disruption? No, they just return everything back to equilibrium. And stabiliting the growth rate requires even more price adjustments. Right?

  6. Gravatar of Steve Steve
    30. October 2011 at 12:28

    Edmund Phelps was asking about NGDP in a Bloomberg interview. I wonder if he ever interacts with Woodford. Here is Phelps’ answer:

    “I think anything like targeting nominal GDP strikes me as otherworldly. I know where that’s coming from of course, but it doesn’t have any attraction for me at all. I think the Fed should be keeping it’s eye on the inflation rate and when things are going well and it can do something to nudge output and employment in one direction or another that’s fine too and whatever happens to the nominal GDP, who cares?”

  7. Gravatar of W. Peden W. Peden
    30. October 2011 at 12:37

    Steve,

    Yeah, Phelps is right: we should pay attention to output and inflation, but NGDP? That’s crazy talk!

  8. Gravatar of Steve Steve
    30. October 2011 at 12:39

    Scott,

    I think the debate about rate vs level targeting is poorly framed. Everyone knows, intuitively, that shocks should be reversed and longstanding policy regimes should not. We know that NGDP changes caused by a financial panic, natural disaster, or war, should be reversed as soon as possible. On the other hand misbegotten policy regimes like the 70s Great Inflation or Japan’s lost (two) decades should still be bygones. A debate emphasizing one year rate vs level targets is artificially binary.

    The debate should be over what INTERVAL of time the Fed target NGDP and what political entity determines the target. Perhaps Congress gives the Fed a 5 year mandate for 25 percent NGDP growth? Or perhaps there can be a more technocratic method for adjusting the target for recent shortfalls and surpluses?

  9. Gravatar of Mike Sproul Mike Sproul
    30. October 2011 at 12:56

    Scott:

    What does an NGDP targeter say should be done to fix a Thailand-style run on the central bank?

  10. Gravatar of W. Peden W. Peden
    30. October 2011 at 15:20

    Steve,

    Selgin proposes targeting NGDP at the trend rate of TFP growth by entering the necessary data into a computer. I imagine that he thinks the NGDP growth rate should change only if the trend of TFP growth changes.

    In fact, of all the proposals of how to target NGDP (and do other important things like getting rid of existing Fed structure) I must say that Selgin’s is the best.

  11. Gravatar of Richard W Richard W
    30. October 2011 at 16:02

    Some of you NGDP targeters should get yourselves over to comment on Gavyn Davies blog where he discusses the Fed communication strategy and NGDP targeting.

    http://blogs.ft.com/gavyndavies/2011/10/30/fed-plans-changes-to-communications-strategy/#axzz1cJCY0Y5A

  12. Gravatar of Morgan Warstler Morgan Warstler
    30. October 2011 at 17:29

    “More likely they’d just shoot for 5%, with no catchup at all.”

    More likely they’d shoot for 4% (or less), with no catch up at all.

    I don’t get why you insist on pretending there are political forces at work here. This isn’t just about the election. This is about opportunistic disinflation.

    At 4%, the Fed is basically locking in low inflation, and assuring conservatives that they cannot EVER let things go too hot again.

    4% they can sell to the Tea Party.

  13. Gravatar of Bob OBrien Bob OBrien
    30. October 2011 at 17:39

    I just read Scott’s FAQ for the first time. It is excellent! I have been reading this blog for a few years now but when I first started reading it I was very lost. It took me many months to figure out what Scott explains so clearly in the FAQ. I highly recommend that readers new to this blog who are not economists start by reading the FAQ.

  14. Gravatar of Morgan Warstler Morgan Warstler
    30. October 2011 at 18:20

    Note, if the GOP takes over in 2012, Scott will be deleting this from the FAQ:

    “Countries that follow conservative “hard money” policies during deflation (the US in the early 1930s, Argentina 1998-02) end up seeing the government taken over by left-wingers.”

    He’ll include an astrisk saying how great I am.

    And he’ll need a better answer for this question:

    “Won’t your policies lead to high inflation in the long run?”

    A the answer is, we’ll worry about inflation when a Democrat is President.

  15. Gravatar of John John
    30. October 2011 at 19:17

    Measuring GDP carries all the problems of measuring inflation and more. Not only is actual GDP data difficult to collect, the private sector gets treated differently than the government. Government spending is completely different than private spending since the government doesn’t run on voluntary transactions.

  16. Gravatar of Morgan Warstler Morgan Warstler
    30. October 2011 at 19:42

    John, there’s also the fast worthless transactions back and forth fake build up GDP.

    I think the hardest one Scott hasn’t dealt with though is the restatement / recalculation of GDP years later.

  17. Gravatar of Greg Ransom Greg Ransom
    31. October 2011 at 07:35

    This is (part) of the point I was making here last year:

    “In my previous post I probably created the impression that I entirely agree with Romer’s post. Those who view me as an inflationist may be surprised to learn that I actually think her recommendation is a bit too expansionary. In 2009 I favored going back to the old (pre-2008) trend line. I still think that policy would be better than the status quo. But any dating of a trend line is arbitrary unless the Fed has set an explicit target. As time goes by more and more debt and wage contracts have been set based on post-2008 expectations. So at this late date it might be more prudent to only go part way back.”

  18. Gravatar of ssumner ssumner
    31. October 2011 at 13:29

    Patrick, The base drift worry actually supports my plan.

    Marcus, Unfortunately, that’s the way the system works.

    Becky, You can’t have both.

    Bill, How can I be too focused on growth rates, when I favor level targeting? I just don’t know exactly where the level should be set right now.

    Steve, Phelps doesn’t get it.

    Any decision of level targeting is arbitrary. But once the regime is in effect, nothing is arbitrary. I have an open mind as to the exact numbers, but a closed mind on the question of whether we should adhere to the regime, once established.

    Mike, I don’t know the details of the Thai example, but if it made the government insolvent, it may not be able to target NGDP. In that case they may be forced to monetize debt.

    Richard, Thanks for the link.

    Bob, Thanks for pointing that out–the FAQ is where beginners should start.

    Morgan, Money was tight in 2008 at Obama won–case closed.

    John, No, it’s far easier to measure NGDP. No guesswork about quality change.

    Greg, Then you were right before me.

  19. Gravatar of Mike Sproul Mike Sproul
    31. October 2011 at 14:52

    Scott:

    “I don’t know the details of the Thai example, but if it made the government insolvent, it may not be able to target NGDP. In that case they may be forced to monetize debt.”

    So we’ve hit on a case where targeting NGDP fails. Here’s a better scenario: The thai central bank has issued 100 mil baht and initially holds assets worth $100mil. 1 baht=$1.
    Then the Thai government starts having trouble payng its bills, so its bonds lose value. The Thai central bank holds alot of those bonds, so let’s say the central bank’s assets fall to $90 mil. A run starts and the central bank redeems 10 mil baht for $10 mil of its assets. Now the central bank has $80 mil of assets backing 90 mil baht, so each baht is worth 80/90=$.89. To stop the run, the central bank suspends convertibility of baht into dollars, but the economy had previously had a real money supply equivalent to $100 mil., and now they only have $80 mil worth of baht circulating. Solution: Issue another $20 mil worth of baht and use them to buy $20 mil of US governent bonds. No need to monetize the thai central bank’s debt. Inflation stops and the money supply is restored to its pre-crisis level.

  20. Gravatar of ssumner ssumner
    4. November 2011 at 18:47

    Mike, I think the sort or run you describe is very implausible. Unless of course the government is actually broke, in which case everyone, including all monetarists, agree you get lots of inflation as the government is expected to print money to pay its bills. But people like to hold base money because it’s convenient, so you don’t get a run unless the government finances are in truly awful shape.

Leave a Reply