Archive for the Category NGDP futures targeting


Reply to John Taylor

John Taylor has a new post criticizing NGDP targeting:

One change is that, in comparison with earlier proposals, the recent proposals tend to focus more on the level of NGDP rather than its growth rate. This removes some of the instability of NGDP growth rate targeting caused by the fact that NGDP growth should be higher than its long run target during the catch up period following a recession. But it introduces another problem: if an inflation shock takes the price level and thus NGDP above the target NGDP path, then the Fed will have to take sharp tightening action which would cause real GDP to fall much more than with inflation targeting and most likely result in abandoning the NGDP target.

I see lots of problems here, but in fairness this may reflect my particular vision of NGDP targeting, which is the “target the forecast” approach.  Under my plan, the Fed would constantly adjust policy so that expected future NGDP (12 or 24 months forward) remained right on target.  Ideally this would involve NGDP futures markets, more likely it would involve an internal Fed NGDP forecast, which also incorporated the consensus private NGDP forecast as well as various asset prices such as TIPS spreads.

Taylor is right that there might be inflation shocks under NGDP targeting, just like there are under inflation targeting.  For instance, the rise in oil prices in 2007-08 caused CPI inflation to rise far above the Fed’s implicit target.  But he’s wrong in assuming these inflation shocks would raise NGDP, indeed NGDP growth slowed to well under 5% during the 2007-08 oil shock.

The deeper problem with this criticism is that wages are not set on the basis of expected inflation, but rather the expected rate of NGDP growth.  That’s why wages in a country like China have been rising at double digit rates for years, despite much lower inflation rates.  It is why wages in the US remained well behaved in 2007-08, even as headline inflation rose to over 5% (as NGDP growth was slowing.)  As long as the Fed keeps targeting NGDP expectations, wage growth will remain anchored.  Workers and employers understand that wages cannot compensate for every spurt in prices at the gas pump.  If actual NGDP does change suddenly, it will be easy to reverse as long as expected future NGDP (and hence wages) remain on track.  (Note; this argument applies best if the Fed targets NGDP per capita, or per working age adult.)

If the Fed had been targeting inflation in 2008 the crisis would have been far worse, as monetary policy in mid-2008 would have been much tighter.  The Fed actually takes both inflation and real growth into account.  But an NGDP target would allow them to do so in a much more explicit fashion, and would have allowed them to ease much more aggressively in late 2008.

Taylor continues:

A more fundamental problem is that, as I said in 1985, “The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.” The same lack of specificity is found in recent proposals.

That may be true of Romer and Krugman, but they were basically endorsing the proposals of others.  And certainly no one can claim that my proposal lacks specificity—it is just as rule-based as Taylor’s famous policy rule.  It also has the advantage of being forward-looking, which is a huge plus in a fast moving financial crisis like 2008.  The Fed used Taylor Rule-like reasoning in deciding not to cut rates below 2% in their September 16, meeting, which occurred right after Lehman failed.  They cited a roughly equal risk of recession and inflation.  Incredibly, the risk they saw was excessively high inflation, not excessively low inflation.  How could the Fed have made such a bone-headed mistake?  They were looking in the rear view mirror, at nearly 5% headline inflation over the previous 12 months.  They should have looked down the road as Svensson suggests, as the TIPS spreads that day showed 1.23% inflation over the next 5 years.  Taylor Rule-type thinking caused the Fed to unintentionally leave money way too tight to hit their implicit inflation and employment targets.

I’m sure that today even Ben Bernanke would agree that they erred in not sharply cutting rates at the September 2008 meeting.  During the fall of 2008 the Fed needed to do enough stimulus so that forecasts of 2010 NGDP remained roughly 10% above actual 2008 levels.  They didn’t even come close, which is why the recession was so much worse than it needed to be.  The sub-prime fiasco made a mild recession almost inevitable, but the fall in NGDP (the biggest since the 1930s), made it far worse than it needed to be.  Sharply falling NGDP expectations in late 2008 led to sharply lower asset prices, which dramatically worsened bank balance sheets.  IMF estimates of expected US banking system losses nearly tripled in late 2008 and early 2009, even though the sub-prime fiasco was already well-understood by mid-2008.  What wasn’t predicted in mid-2008 was the catastrophic fall in NGDP over the next 12 months.

At first glance Taylor’s piece looks like a critique of NGDP targeting.  But on close inspection it is something different.  It is a discussion of tactics; level versus growth rate targeting.  Rules versus discretion.  I’ve added the issue of forward-looking versus backward-looking rules.  These are all interesting issues, and I actually agree with Taylor on the importance of policy rules.  He is well aware that some of the most distinguished proponents of NGDP targeting (such as Bennett McCallum) have proposed explicit NGDP policy rules.  He also knows that the dual mandate embedded in NGDP targeting is not that different from the dual mandate embedded in the Taylor Rule.  Readers of critiques by Taylor and Shlaes need to keep in mind that their real target isn’t NGDP targeting, it’s discretion.  I hope John Taylor will consider jumping on board and writing an explicit “Taylor Rule” for NGDP targeting, so that if the Fed does move in that direction they do so in a responsible way.

BTW,  What’s the non-discretionary Taylor Rule suggestion for Fed policy if rates fall to zero and further stimulus is needed?

HT:  Marcus Nunes

The connection between level targeting and futures price targeting

I’ve talked a lot about the need for level targeting, i.e. setting a growth trajectory for NGDP and promising to make up for any near term overshoots or shortfalls.  And I’ve also talked a lot about the idea of targeting the price of NGDP futures contracts.  But I don’t recall talking about the connection between these two policies, which might shed some light on the importance of level targeting.

Policy lags are one of the difficulties that face monetary policymakers.  The Fed often doesn’t even know that the economy is in recession until several months after the downturn has begun (based on the retrospective dating of the cyclical peak by the NBER.)  It turns out that both level targeting and futures targeting help address this issue, in fairly similar ways.

Imagine a model where millions of people and businesses observe local demand shocks, and that data is aggregated 3 months later in the quarterly NGDP numbers.  It’s quite possible that the “market” would know things that no single individual would know—as the market will reflect aggregate optimism and pessimism, which is partly based on all those local demand shocks.

The advantage of NGDP futures targeting is obvious when there are policy lags.  The market will sense velocity changes before the Fed does, and offset them with adjustments in the base (or fed funds rate if you prefer to think in Keynesian terms.)  But how about level targeting, how is that like futures targeting?

Suppose that pessimism causes velocity to drop 2% before the Fed is able to notice and take corrective action.  Also suppose the Fed is doing plus 5% NGDP level targeting.  The markets will expect the Fed to return the economy to the trend line over the next 12 months.  This means they will now expect 7% NGDP growth; the normal 5%, plus another 2% to offset the near term shortfall.  This means they will expect easier money than if the Fed was doing growth rate targeting, and letting “bygones be bygones.”  More expansionary than if they settled for 5% growth after the 2% shortfall.

Now let’s assume that the markets notice the shortfall before the Fed does, and they expect the Fed to ease as soon as the shortfall is noticed.  That is, imagine a period like September 2008, when the TIPS market saw rapid disinflation but the Fed was still worried about high inflation.  In that case the markets will expect Fed easing before the Fed does.  Now recall than in modern new Keynesian economics the current level of aggregate demand doesn’t just depend on current short term rates, but also expected future short term rates.  I.e. it depends partly on longer term rates.  The anticipation of Fed easing will immediately reduce future expected short term rates, and will immediately reduce long term rates.  The market does the Fed’s work before the Fed even realizes there is a problem.

So with level targeting the market will be moving expected future interest rates around in such a way as to keep expected future NGDP (12 months out) right on target.  And here’s the best part of all.  Remember my initial assumption that NGDP temporarily fell below target, before the Fed corrected the problem?  It turns out that with level targeting the initial deviation from the target trajectory will be much smaller than if there was growth rate targeting, even if the Fed makes no immediate attempt to get the economy back on track.  Because the market will depress future expected rates, they will boost AD in the current period, even before the Fed noticed that there was a problem.

It’s not quite as good as NGDP futures targeting, but it comes so close that I’d guess it would deliver more than 90% of the potential efficiency gains from NGDP futures targeting, maybe 95%.  Given the current sorry state of monetary policy, that’s a lot of $100 bills lying on the ground waiting to be picked up.  Let’s hope the Fed notices them when it meets next week.

Why NGDI targeting is superior to NGDP targeting

The title of this post is a joke, which I’ll explain later.

Tyler Cowen linked to an interesting article in the FT, explaining why Gross Domestic Income is much more accurate than Gross Domestic Product:

Since the start of the recession, GDI has proved the more accurate depiction of US economic performance, according to [Jeremy] Nalewaik’s work. As better data have become available and the Bureau of Economic Analysis (which calculates both) has accordingly revised its earlier estimates, it is GDP that has been adjusted in the direction of GDI rather than the other way round.

Have a look at this chart from Nalewaik’s recent paper:

Neither measure was perfect, but early GDI estimates were much closer than GDP to later revisions of both measures. Perhaps more tellingly, GDI started signaling an economic slowdown in the middle of 2007 even as GDP kept climbing. Early GDI estimates also turned out to better reflect the severity of the recession.

To give the most glaring example, the initial GDP estimate for the fourth quarter of 2008 showed that the economy contracted by 3.8 per cent. It was released on January 30, 2009 “” about three weeks before Obama’s first stimulus bill passed. That number was continually adjusted down in later revisions, and in July of this year the BEA revised it all the way down to a contraction of 8.9 per cent.

The FT is discussing real GDP and real GDI, but I believe the same applies to the nominal versions.

Some commenters have pointed to a flaw in NGDP targeting, level targeting.  If there is a sudden and massive revision in the current level of NGDP, it would force the Fed to shoot for much more or less than 5% NGDP growth over the following year.  That could be destabilizing.  Generally the revisions to current NGDP aren’t that large, but on occasion they can be significant.  Thus I now think NGDI is the better target.

The article also sheds light on the ultra low RGDP growth in early 2011, which many took as evidence that QE2 failed.  But at the time it seemed like QE2 was working, as the monthly jobs figures increased substantially, and other data such as ISM numbers showed an extremely strong economy.  So how could the RGDP numbers have been so weak?

Speaking broadly, two types of evidence suggest that the initial estimates of GDI are typically better than the initial estimates of GDP.

First, a variety of business cycle indicators that should be highly correlated with output growth-including the Institute for Supply Management surveys, the change in unemployment, some financial market variables, and even GDP growth forecasts themselves-have actually been more highly correlated with GDI growth than with GDP growth in recent decades.

That last item on the list is worth emphasizing: economists forecasting GDP growth have produced median forecasts that have tended to be more highly correlated with GDI growth than the variable they are trying to forecast.  It is also notable that GDI growth tends to predict GDP growth next quarter better than GDP growth itself.  All this suggests initial GDI growth is picking up some real fluctuations in the economy that are being missed by the initial GDP growth estimates.

Second, initial GDI growth estimates have tended to predict revisions (typically years later) to initial GDP growth estimates, especially since the mid-1990s.  So, if initial GDI growth is above initial GDP growth, GDP growth tends to revise up, and if initial GDI growth is below initial GDP growth, GDP growth tends to revise down.

For an example of the latter, just look to the recent recession.  In March 2009, the Bureau of Economic Analysis announced that real GDP declined 0.8 percent from the fourth quarter of 2007 to the fourth quarter of 2008, while their GDI calculations showed a much more substantial decline of 2.1 percent.  The latest Bureau of Economic Analysis estimates show declines over that time period of about 3 percent, using either measure.

So, while neither measure initially captured the full severity of the downturn in 2008, the picture painted by the initial GDI estimates was quite a bit closer to the revised figures (which incorporate more complete data and are generally assumed to be more accurate).

What is GDI telling us about the economy now vs what GDP is telling us?

GDI paints a less-bleak picture of the economy recently.  In the first quarter this year, the latest real GDP growth estimates show annualized growth of 0.4 percent, while the latest real GDI growth estimates show 2.4 percent growth.  Other economic indicators like the Institute for Supply Management surveys and the change in the unemployment rate were looking quite healthy over the first few months of this year, suggesting GDI was more accurate in the first quarter.  In the second quarter this year, GDP growth is currently estimated at 1.0 percent while GDI growth is 1.5 percent, so GDI again looks better, but the difference is less sharp.

So the real GDP estimate for the first quarter of 2011 was probably wrong.  To be sure the RGDI number is also disappointing, but at least it isn’t horrible.  Unfortunately it will be many years before we know what actually happened, but for now I’m sticking with ISM numbers and jobs numbers as the best near-term indicators.

Even by those criteria, QE2 was far less than needed, but I’d add that ever since the Fed signaled (in the spring) that it wasn’t going to extend QE2 after June, the economy has done even more poorly than during late 2010 and early 2011.  QE2 was far too little to make a major dent in the economy, but it was probably still better than nothing, which is all we have today.

Now for the joke.  Some readers might have assumed that I am abandoning my advocacy of NGDP targeting.  No so, because NGDP and NGDI are exactly the same thing.  Thus I still favor NGDP targeting.  However government estimates of NGDP and government estimates of NGDI do differ.  And it seems like reported NGDI is the more accurate estimate of actual NGDP/NGDI.  Thus the actual implementation of NGDP targeting should involve the targeting of futures contracts with a value at maturity linked to future announcements of NGDI.

We’re getting closer

The blogosphere response to the recent Swiss move is quite interesting.  But let’s back up a minute so that I can better explain why I am bemused by the discussion.  Recall that I look at monetary policy from an asset price approach.  Easy money is a policy that pushes NGDP futures prices above target, and vice versa.  If the government is so monumentally stupid that it hasn’t spent a few million dollars to create and subsidize trading in an NGDP futures market, and is doing monetary policy with a blindfold on, then look at a collection of assets like stocks, commodities, TIPS, etc, and then estimate NGDP growth expectations.

I spent lots of time studying the 1930s, when FDR routinely moved the price of gold around as a lever of monetary policy, and all the markets responded exactly as you’d expect if the policy was credible and effective.  I’m very comfortable operating in a world where the central bank pegs the price of some sort of nominal anchor.  That’s how I think monetary policy works, or should work.

Lots of proponents of monetary stimulus on both the left and the right are basically saying “Look, if the Swiss can do it, why can’t we?”  JimP sent me an excellent Ryan Avent post that makes this point clearly.  First he discusses the Swiss move, and then says:

There seems to be more scepticism that the Fed could similarly talk the economy toward a specific inflation or nominal growth rate. I understand the reason for the intuition; prices and wages aren’t set in the same clear way that security prices are. The principle is the same, however. If the Fed declared””credibly””that it would intervene in markets such that nominal growth in 2012 was 6%, asset-market prices should adjust immediately, pushing firms and households to behave in a more optimistic way, leading to faster growth. Expectations for growth couldn’t rise too high, however, lest the spectre of Fed tightening be raised, leading actors to push the economy toward the desired nominal target.

The Fed would need to act enough to demonstrate its credibility, and nominal growth of 6% wouldn’t guarantee anything about real growth. But examination of the Swiss National Bank’s action, and the resulting effect, should give us pause. From it, we can either conclude that the Fed is implicitly targeting a higher rate of nominal growth but isn’t credible, or that the Fed is credibly targeting growth within a range consistent with actual recent experience. In fact, I think it’s a bit of both. Ben Bernanke may say he wants a faster recovery, but the Fed’s actions are inconsistent with his statements, and markets and economic actors have therefore concluded that the Fed is happy with current growth rates. Nominal growth above 5% per year is not the rate the markets are looking for. And so it’s not the rate they get.

At first I was slightly annoyed by the “Ben wants more growth” comment.  Bernanke has consistently said the Fed has plenty more ammunition.  If they aren’t using it, it’s because the Fed doesn’t think it’s needed.  It doesn’t think faster expected NGDP growth would be desirable.  I imagine Bernanke is disappointed by NGDP growth in the recent past, but he favors growth rate targeting, not level targeting.

But on second thought I realized that the Fed isn’t Avent’s intended audience.  Very few people know what Avant and Yglesias and us quasi-monetarists know–that the only solution for the recession is faster NGDP growth, and only the Fed can deliver it.  It’s almost pathetic to listen to NPR these days.  You have all these earnest liberals who sincerely want Obama to succeed, talking about various screwball ideas to create a few thousand jobs here or there, when we need 10 million jobs.  Only the Fed can to that.  We need to wake up Congress, the WaPo editorial board, and all the other movers and shakers.  We need for them to suddenly realize; “You mean to tell me if the Fed did something analogous to what the SNB did, it would create millions of jobs!  And they know they can do it, but just don’t happen to think the economy needs more demand, more spending, more NGDP!”  When that happens the Fed will suddenly be under tremendous pressure to create jobs.  NPR also has lots of heart-wrenching stories about what happens to average people in America when they’ve been unemployed for a long time.  I wonder how the hawks at the Fed can be so confident that more stimulus wouldn’t help those people.  Do they even listen to those stories?

One person at the Fed does realize the severity of the jobs problem, and that the Fed has the duty to address it.  Several commenters sent me an excellent speech by Chicago Fed President Evans:

Some believe that this pause is entirely appropriate. They claim that the economy faces some kind of impediment that limits how much more monetary policy can do to stimulate growth. And, on the price front, they note that the disinflationary pressures of 2009 and 2010 have given way to inflation rates closer to what I and the majority of Fed policymakers see as the Fed’s objective of 2%. These considerations lead many to say that when adding up the costs and benefits of further accommodation, the risk of over-shooting our inflation objective through further policy accommodation exceeds the potential benefits of speeding the improvement in labor markets.

I would argue that this view is extremely, and inappropriately, asymmetric in its weighting of the Fed’s dual objectives to support maximum employment and price stability.

Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.

In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.

The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment.

And he saves the best for last:

There are other policies that could give clearer communications of our policy conditionality with respect to observable data. For example, I have previously discussed how state-contingent, price-level targeting would work in this regard.  Another possibility might be to target the level of nominal GDP, with the goal of bringing it back to the growth trend that existed before the recession. I think these kinds of policies are worth contemplating””they may provide useful monetary policy guidance during extraordinary circumstances such as we find ourselves in today.

Evans makes me seem like a hawk.  I think it’s too late to go back to the old trend line (we’re about 12% below it.  I’d be happy going 1/3 of the way back—7% NGDP growth for two years and 5% thereafter.

I hope this doesn’t sound too conceited, but I can’t help taking satisfaction with the way the conversation over monetary policy is developing:

1.  Fed people discussing NGDP targeting, level targeting.

2.  The Economist magazine comes close to endorsing NGDP targeting.

3.  Ryan Avent talking about monetary policy in terms of pegging asset prices, and then drawing analogies with NGDP targeting.

4.  Nick Rowe is drawing upward sloping IS curves (I plan a post when I have time.)

My very first paper was written in 1986, presented at the AEA in 1987, sent 4 times to the JME with revise and resubmits before being rejected, then published in 1989 in an obscure British journal.  The topic was how the central bank should create NGDP futures contracts, and then peg the price in such a way that the market determines the money supply and interest rates.  NGDP expectations are always on target.  I still feel that’s the end of macro.  No more fiscal multipliers.  No more broken windows fallacies.  No more confusing of structural and demand problems  No more mercantilist arguments for reducing unemployment.  No more demands that GM must be saved to preserve jobs.  Students could just take one semester of econ—we could stop calling it “microeconomics” and start calling it “economics.”

I feel we are getting closer every day.  I just hope I live long enough to see it happen.

PS.  I’m still running way behind on comments–I know there are many from before my vacation that I haven’t even read.  My priorities are:

1.  Get my ideas out there before the critical Sept. meeting.

2.  My job.

3.  Dealing with flooding in my basement.

4.  Dealing with papers people send me for comments.

5.  Buy a new toilet.

6.  Answer comments.

You’ll just have to wait.

More from the FT

Here’s Joseph Cotterill:

Anyone for Fed targeting of nominal GDP futures?

Are  we gaining converts?