Making life easier for central bankers

This is from an excellent article at Free Exchange:

THE Bank of England released its quarterly inflation report this morning. It also published the letter from Mark Carney, governor of the bank, to George Osborne, Britain’s chancellor of the exchequer, that was required to explain why inflation””currently 0.5%””had deviated more than a percentage point below the bank’s target of 2%.

According to the report’s forecasts, inflation will turn negative in the coming months as a result of the huge fall in oil prices. However, the letter emphasises the short-term, one-off nature of the oil-price shock, which will fall out of the numbers relatively quickly and so requires no offsetting action. Mr Carney noted that in 68% of the categories which make up the CPI, prices are rising. In any case, the bank thinks it takes 18-24 months for monetary policy to have an impact on the economy; the oil-price fall came on much more quickly.

When asked whether the bank was overlooking the oil-price decline because it was unanticipated or because it was external to the economy, Mr Carney said it was the former. Were the bank able to forecast supply shocks in time to offset them, it would have to do so under its inflation-targeting mandate (“If we knew it, and could lean against it, we would”). Mr Carney hinted that in such a situation, it might be worth reconsidering the mandate.

It was interesting to listen to Carney’s comments in the second link—you can see why the Free Exchange writer saw Carney hinting that another mandate might be more appropriate.  At the same time, Carney sort of backed off before saying what you expected him to say—perhaps uneasily aware that he wasn’t really free to speak his mind on this issue; the mandate is up to the government.

On the other hand, when people are able to speak their minds it seems as though increasing numbers see the obvious virtues of NGDP targeting, including academics, bloggers, and indeed Mr Carney himself when he spoke in Toronto a few months before taking the BoE job.  Here’s Free Exchange:

That’s one of the problems with inflation-targeting regimes. The central bank uses its interest rate to steer demand. Demand shocks cause output and inflation to move in the same direction; if demand rises, both output and inflation tend to go up too. But a positive supply shock””like the recent fall in oil prices””increases output while suppressing inflation. To offset the deflationary effect of a “good” supply shock, the bank would have to lower interest rates to stimulate the domestic economy. That is, the bank would have to let the economy overheat. In the event of a negative supply-shock, such as an oil-price rise, the bank would have to slow down the domestic economy””potentially causing unemployment””in order to generate domestic deflationary pressure. The overall effect is to increase the volatility of domestic output, rather than promote macroeconomic stability, one of the intentions behind inflation targeting.

As has been frequently pointed out in the blogosphere, if the bank targeted nominal GDP (NGDP) rather than inflation, there would be no such problem. Under a such a regime, the bank would concern itself only with nominal spending in the economy, which can rise due to inflation or due to output growth (the supply-side of the economy determines the split between the two). The bank could therefore tolerate supply-side shocks which boosted growth and reduced inflation, as they would have an offsetting effect on NGDP. There would be no need to manipulate domestic output to offset forces from abroad.

Carney would have a much easier time at press conferences if he wasn’t constantly having to explain BoE policy that on the surface seemed inconsistent with inflation running much too high or much too low relative to the 2% mandate.  He could simply announce the NGDP growth rate, and explain in a very simple and transparent way why the BoE responded to that information with their current policy stance.

Carney also announced that the current policy rate (0.5%) was no longer viewed as the lower bound.  Here’s Britmouse:

The Governor of the Bank of England announced yesterday that interest rates are no longer at the Zero Lower Bound.  This was a rather under-the-breath “Oh, and by the way” announcement, which is kind of funny given how much some economists have staked on the significance of the ZLB.

.  .  .

In choosing to hold rates at 0.5%, the MPC is choosing to set rates above the new, lower, actual ZLB.  The Bank of England is no longer at the ZLB.

The good news is that now the Bank is off the ZLB, reality-based Keynesians will return to talking about UK macro policy in terms of conventional monetary policy and will go quiet about the need to use fiscal policy to control AD.  Right?

The other thing I find amusing is that Keynesians kept insisting that if only central banks could have cut rates further they would have.  That may have been the case at one time, but obviously is no longer true.  The BoE could cut them right now, but chooses not to.

PS.  Yichuan Wang has a good post criticizing my posts on the musical chairs model:

I have no disagreement on the policy advice. But I do have an issue with the way that Scott justifies his “musical chairs” model of employment. In particular, the key stylized fact”Š”””Šthe countercyclicality ratio of wages divided by nominal GDP”Š”””Šis not unique to his model. As such, it does not provide any smoking gun for the market monetarist claim that fluctuations in nominal GDP are key to understanding the business cycle.

.  .  .

Now, I still believe that a model of nominal GDP + sticky wages is a powerful framework. Wages are indeed sticky, as evidenced by a spike in the wage change distribution at 0. And if wages are sticky, monetary tightness and declining nominal GDP mean that people are paid high real wages and as such there are fewer jobs. Alternatively, you can view it as a liquidity issue as companies just don’t have enough nominal cash flows to pay those persistently elevated wages. So I don’t think there are too many issues with the underlying framework. I would just advise more caution on the way that statistical evidence is used.

I should be more careful in my discussion.  Yichuan is right that the correlations by themselves don’t provide much support for the musical chairs model, as they are also consistent with other models.  You might think of them as a necessary condition.  You actually need several assumptions:

1.  The fact that W/NGDP is highly correlated with unemployment.

2.  The fact than nominal wages are very sticky in the presence of high frequency NGDP shocks (lasting one, two or three years.)



9 Responses to “Making life easier for central bankers”

  1. Gravatar of Benjamin Cole Benjamin Cole
    16. February 2015 at 04:56

    As I am more of a pundit than a full-fledged economist, I try to think about how to sell Market Monetarism to the public, the policy-makers, or the organizational framework of the Fed, etc.

    Just a thought: We Market Monetarists have been talking about NGDP targeting, or NGDPLT targeting.

    I wonder if the word “nominal” is necessary, and even suggests a little bit of peek-a-boo, or three-cup monte.

    At worst, we might be painted as purely concerned with a nominal representation of GDP, and not “real” GDP.

    As in, “Those Market Monetarists do not even care if the nominal GDP grows by 5%, all inflation.”

    Market Monetarism does sound nutty, from that perspective. And we will be framed that way, if ever we can take over the Fed.

    I wonder if Market Monetarists should just say we are targeting steady growth in GDP as reported to a target level, quarter to quarter. After all, the GDP figures are reported in nominal terms.

    Through this last recession, we would have been arguing for more robust GDP growth. That certainly would sound fine to the public.

    Just a thought.

  2. Gravatar of ssumner ssumner
    16. February 2015 at 05:23

    Ben, In a perfect world the default meaning of “GDP” would be nominal, just as it is for interest rates, wages, stock prices, and many other variables. There should only be GDP and real GDP.

  3. Gravatar of Britonomist Britonomist
    16. February 2015 at 07:13

    Unrelated but I’m liking this Hypermind widget, seems that it’s been increasing slightly by 0.3 percentage points since I last checked it. Could be a good way to track market sentiment, depending on who is involved in the bets; how often is it updated?

  4. Gravatar of Charlie Jamieson Charlie Jamieson
    16. February 2015 at 08:24

    Ben, agreed that you have to show that MM or targeting NGDP will lead to increased growth and/or higher standards of living. Right now it sounds to the casual reader that you are targeting higher inflation. Tell me how higher inflation will specifically make the economy healthier.

    Also have to address this question: In order to smooth out growth so that it’s consistent over time, you have to know what the growth line looks like over the next 10 years. So, for example, if you have 4 pct real growth in Year 1, you have to know it that’s above or below the trend line. How do you know that?
    Finally, you have to address this issue: Can you *really* move inflation? If it’s 2 pct, can you really move it to 2.56? You can take a giant economy and fine tune it to that degree? What specific actions would you take? Who would be the winners and losers?

  5. Gravatar of Kenneth Duda Kenneth Duda
    16. February 2015 at 19:19


    > Right now it sounds to the casual reader that you are
    > targeting higher inflation

    We are targeting higher demand (when NGDP is below target), and there are times when that will lead to some prices to increase. However, inflation itself is not being targeted.

    > Tell me how higher inflation will specifically make the economy healthier.

    There are cases where relative price adjustment is needed to restore full employment. For example, in 2009 there were 9 million unemployed because the marginal return on hiring a worker at prevailing wages was negative because of wage stickiness and slack demand. Monetary expansion was needed to restore full employment because increased demand allows some prices to rise while wages stay stuck — this price adjustment restores full employment.

    > In order to smooth out growth so that it’s consistent over time, you
    > have to know what the growth line looks like over the next 10 years.

    You are confusing real and nominal growth. NGDPLT makes no claim of stabilizing real growth. NGDPLT provides a stable macroeconomic climate (stable aggregate demand) that is most conducive to maximum (as opposed to stable) real growth.

    > Can you *really* move inflation?

    Again, MMers aren’t trying to move inflation. The question you should be asking is, can you really target aggregate nominal spending (NGDP)? And the answer is, yes. If total spending is too low, how about pegging the dollar to the yen, $1 = 1 Yen. If that doesn’t cause some spending… but this sort of extreme action would not be needed under NGDPLT. Once the market saw the Fed could target the level-path of NGDP, firms would factor NGDP expectations into their planning and hitting the target would be as easy as the way the Fed targets the value of the 5-dollar bill.

    > If it’s 2 pct, can you really move it to 2.56?

    It makes no difference if inflation is 2% or 2.56%.

    > Who would be the winners and losers?

    The winners are everyone. The losers are economists with the wrong models.


    Kenneth Duda
    Menlo Park, CA

  6. Gravatar of Brian Donohue Brian Donohue
    16. February 2015 at 20:12

    Very good post.

  7. Gravatar of benjamin cole benjamin cole
    16. February 2015 at 23:16

    Charlie J;
    I am a bit of an oddball in market monetarism circles. I contend that the economy is not very inflation-prone these days. Ergo, almost any increase in demand is met by an increase in supply.
    I would rebate FICA taxes to both workers and employers and finance through QE bond-buying and the placement of those bonds in Social Security and Medicare trust funds.

  8. Gravatar of ssumner ssumner
    17. February 2015 at 06:09

    Britonomist, Let’s hope so.

  9. Gravatar of J.V. Dubois J.V. Dubois
    18. February 2015 at 05:51

    As famous quote says: “Correlation is not causation but it sure is a hint.”

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