As far as I can tell there is a pretty strong desire on the part of both Mark Carney and the Cameron coalition government for a more pro-growth policy from the Bank of England. A policy that would allow them to continue with fiscal austerity, while still providing for reasonable levels of demand growth. We know that Carney has some interest in NGDPLT, as do some people in the Cameron government. But there is also substantial opposition to abandoning the 2% inflation target. Doing so risks a loss of credibility and confusion among the public (some claim), as NGDPLT is not well understood. I have a proposal that would deliver at least 95% of the anti-cyclical benefits of NGDPLT, while preserving 2% inflation as a long run target. It’s actually a variant of flexible inflation targeting, with strong NGDP stabilizing properties. First I’ll describe the policy if we were starting from full employment. Here’s how it works:
1. The Treasury estimates Britain’s long term sustainable trend RGDP growth each 2 years. Suppose the initial forecast is 2%.
2. The Treasury instructs the BOE to set a 4% NGDP growth target for the next 4 years, with level targeting. This would be 2012 to 2016. The target will be updated every two years as new long term growth estimates come in from the Treasury.
3. Suppose in 2014 the Treasury estimates Britain’s long term trend growth has fallen to 1.8%. They would instruct the BOE to aim for 3.8% NGDP growth between 2016 and 2018. That gives markets plenty of time to adjust. The growth target would remain at 4.0% from 2014 to 2016.
4. Suppose that by 2016 the Cameron supply-side reforms seem to be working, and long term trend growth is estimated at 2.1%. Now the Treasury instructs the BOE to aim for 4.1% trend growth between 2018 and 2020. The target remains 3.8% between 2016 and 2018.
If we started from a position of high unemployment, the initial target path would involve some catch-up in NGDP, before leveling off at the steady state. How much is a judgment call. After that the only discretion is the Treasury’s trend growth estimates.
To some NGDPLT supporters it might seem I’m giving away the store with this compromise. Not so. Trend RGDP estimates evolve slowly over time, and hence the adjustments in the NGDPLT path would be very gradual. Now imagine a trend line with those sorts of modest adjustments superimposed over the dramatic crash in NGDP that occurred in Britain and elsewhere in 2008-09. It’s easy to see that you’d still get at least 95% of the anti-cyclical properties in a recession, maybe even more. Remember that at any point it time a minimum of two years in trend NGDP growth would be “locked in,” and as much as 4 years of nominal growth. The target NGDP growth path would not be perfectly smooth, but it would be smooth enough to dramatically stabilize the business cycle.
The other advantage is that the government could still adhere to its 2% long run inflation objective. Note that 2% inflation is the only number built in to the policy. The NGDP target paths are those believed to be most likely to produce 2% inflation in the long run. I don’t see how it would be wrong to describe this as “flexible inflation targeting” if the government thinks that label is essential for political purposes. Remember, it’s not as if the current policy rigidly adheres to aiming for 2% inflation at each and every moment in time. The BOE has already been one of the most “flexible” of the flexible inflation targeting central banks. It’s failure in 2009 (and again in 2011) was not due to a lack of flexibility, it was due to a lack of level targeting, and a lack of recognition that NGDP, not inflation, is the key short term variable to focus on.
All the agonizing decisions about how fast to proceed with fiscal austerity are not agonizing because of how fast they might reduce inflation, they are agonizing because of worry about how fast they’ll reduce NGDP. The public cares more about NGDP than people think; it’s just that the public doesn’t really understand the term. They think in terms of “the economy.” But anyone who thinks the public doesn’t care about NGDP should consider the following: Ask people if they care about their own personal nominal incomes. About how big a raise their boss gives them, or whether they’ll see more investment income, or whether they lose their jobs. Then think about the fact that NGDP is simply the sum of all (gross) nominal incomes in the economy.
Yes, people also care about real incomes over time, but the central bank can’t control that in the long run. And in the short run NGDP and RGDP are highly correlated. So tell me again why the public doesn’t care about NGDP instability.
PS. Astute readers will notice that I get this seemingly miraculous compromise by applying “let bygones be bygones” to errors in RGDP trend growth estimates, but adhere to rigorous level targeting of NGDP. That does lead to a policy that fails to stabilize the price level along a 2% trend line, but we already have that sort of base drift in the price level in the various inflation targeting regimes used throughout the world.
PPS. If the proposal is not destroyed in the comment section, I would appreciate if influential readers would pass this along to important policymakers that they know.