Commenter Ram had a very interesting comment on why NGDP level targeting currently seems much better than flexible inflation targeting, even though in theory they shouldn’t be much different:
I support rules over discretion, too. Think about it this way: Suppose the Fed is targeting nominal variable X(t) at a value of x(t). At every instance, the Fed is adjusting its stance so as to ensure that E[X(t)] = x(t). x may vary with t, and yet this is still a rule in the only sense that matters, because it’s spelled out in advance, and adhered to without exception. Even if t (time) isn’t the dependent variable–say the output gap is, as in flexible inflation targeting, for example–it’s still a rule if the Fed implements it in a wholly non-discretionary manner (say by having some set, publicly communicated model of potential output). Nothing about the advantages of rules over discretion favors targeting one nominal variable over another.
Now, suppose I have a rule that says at any and all times, I will pursue inflation target I(o), where o is the size of the output gap. Suppose also that I is increasing in o. In that case, there is a sense in which I’m targeting inflation, in that at any and all times my objective is to keep inflation at a particular level. It’s just that when the output gap gets really big, that level is higher then when the output gap gets really small. If pursued rigorously (as a rule), then what the Fed would do right now is say: “Listen, normally we like 2% inflation because we’re normally able to keep the output gap at a tolerably low level. Right now, however, with interest rates really low, it’s getting bigger than we’d like. So we’re going to target 4% inflation until the output gap falls back to tolerably low levels, after which we’ll go back to our normal 2% target.” This would be following a rule, it would be targeting inflation, and it would overcome the zero lower bound. In a perfect world, it would be optimal, just as optimal as the right NGDP level target.
What the crisis has shown, Scott and I believe, is that in practice it’s really hard for the Fed to follow a rule of that kind. Why? My answer is sticky policies, or sticky targets. I don’t have good microfoundations for such stickiness, but then I never really bought any of the micro-stories behind price or wage stickiness either. Stickiness in the data is enough to convince me. In light of sticky policies/targets, some policies that would be just as good as others in the flexible policy world are better than others in the stick policy world. NGDP level targeting versus flexible inflation targeting is such an example. But it’s useful to note that sticky policies are a fact of political life, not a fact of economic life per se.
So in theory the Fed should have responded very aggressively in 2008 and early 2009, as both the inflation rate (low) and the output gap (big) signalled monetary policy was much too tight. But policy is “sticky” or slow to adjust. I’d add that this isn’t just a zero bound problem. During the entire great NGDP collapse of June to December 2008, the fed funds target was consistently above the zero bound. The Fed was slow to adjust policy. Earlier I argued that slow policy adjustment was the reason why America doesn’t have mini-recessions; real shocks aren’t even large enough to cause mini-recessions (much less full fledged recessions) and monetary shocks end up much bigger than the Fed intended, because the Fed is slow to adjust policy when changes in the Wicksellian equilibrium rate cause policy to switch from expansionary to contractionary.
Level targeting avoids policy stickiness, as market expectations stabilize policy when the central bank is slow to react. This is a great observation by Ram, and is precisely the sort of thing that abstract macro models tend to overlook. Policies that work well on paper may not work well in the real world.
PS. David Beckworth and Ramesh Ponnuru have an excellent new piece in the National Review advocating NGDPLT.