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I find much value in the idea of the Federal Reserve adopting a nominal GDP target. It provides a rule-based system to guide monetary policy and an anchor to economic expectations. It might even allow monetary policy to be purely market-guided. By avoiding major monetary policy errors, it is far less likely the U.S. economy would suffer the sort of major contractions that lead to financial crises whose aftermaths are often ones of expanded government through bailouts and new regulation and fiscal stimulus.
Engineers test system designs against what are called “boundary conditions”. So, let’s run a simple test on NGDP targeting. What if the Fed took Scott Sumner’s advice and (somehow) produced NGDP growth of 5% from now on? And, what if (somehow) Congress enacted a solution to the “fiscal cliff” that eliminated the corporate income tax, thus causing real GDP growth to surge to 7%? Answer: Sumner’s system would break, and it would have to be abandoned. In the process, whatever credibility that the Fed had gained by adopting a rules-based system would be lost.
Wait, is Woodhill talking about a spurt of high growth like the U.S. had coming out of the 1981-82 recession? Or he is talking about high-growth New Normal where the U.S. grows at China-like rates for a sustained period? If it is the latter, then the point is ridiculous. The U.S. economy is not going grow at 7% in real terms this side of the Singularity. And a quarter or two of high, bounce-back growth after a deep recession really poses no problems for NGDP targeting since the point is to get the the growth rate back to a yearly trend. Lars Christensen explains:
It is also key that the Market Monetarists are in favour of targeting the level path of NGDP rather than the growth of NGDP. Typically, Market Monetarists prefer a moving target in the sense that the central bank targets a path for the level of NGDP with a fixed growth rate of, for example, 5%. An advantage of targeting the level rather than the yearly growth of NGDP is the rule hashistory, so if the central bank overshoots (undershoots) its target one year then it will have to make up for this in the following period. This is contrary to money supply growth rules or an inflation target, both of which are forgiving rules. Hence, if the inflation target is overshot one year, the central bank will not pay back the following year. Level targeting therefore anchors long-‐term expectations to NGDP better than a growth-‐based rule. It should also be noted that NGDP targeting will reduce short term fluctuations as the public expects faster going forward whenever growth falls below target in the near term.
UPDATE: My guy Joe Lawler over at RealClearPolicy reminds me that Scott Sumner addressing the point of above-average growth in his National Affairs, while also explaining how a market-based NGDP targeting system would work:
Another approach — which would be more radical, but perhaps also more effective — would limit the Fed’s role to setting the NGDP target, and would leave the markets to determine the money supply and interest rates. This would mitigate the “central planning” aspect of the Federal Reserve’s current role, which has rightly come under criticism from many conservatives. To give a simplified overview, the Fed would create NGDP futures contracts and peg them at a price that would rise at 5% per year. If investors expected NGDP growth above 5%, they would buy these contracts from the Fed. This would be an “open market sale,” which would automatically tighten the money supply and raise interest rates. The Fed’s role would be passive, merely offering to buy or sell the contracts at the specified target price, and settling the contracts a year later. Market participants would buy and sell these contracts until they no longer saw profit opportunities, i.e., until the money supply and interest rates adjusted to the point where NGDP was expected by the market to grow at the target rate. …
Nominal GDP targeting would produce lower than average inflation during a productivity boom. Indeed, one criticism of inflation targeting is that, because central banks focus on consumer prices, they allow asset bubbles to form, which eventually destabilizes the economy. Nominal GDP targeting cannot completely eliminate this problem, but it can impose more monetary restraint during periods of high-output growth than can inflation targeting.
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