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The idea that the Fed should target nominal GDP as a way of better balancing its inflation-unemployment dual mandate got a HUGE boost at the Jackson Hole meeting from a paper by economist and monetary policy expert Michael Woodford of Columbia University. I think of this idea as a Milton Friedman 2.0 approach to Fed policy.
The key bits:
An alternative that I believe should be equally easy to explain to the general public, but that would preserve more of the advantages of the adjusted price-level target path, would be a criterion based on a nominal GDP target path, as proposed by Romer (2011) among others. Under this proposal, the FOMC would pledge to maintain the funds rate target at its lower bound as long as nominal GDP remains below a deterministic target path, representing the path that the FOMC would have kept it on (or near) if the interest-rate lower bound had not constrained policy since late 2008. Once nominal GDP again reaches the level of this path, it will be appropriate to raise nominal interest rates, to the level necessary to maintain a steady growth rate of nominal GDP thereafter.
Essentially, the nominal GDP target path represents a compromise between the aspiration to choose a target that would achieve an ideal equilibrium if correctly understood and the need to pick a target that can be widely understood and can be implemented in a way that allows for verification of the central bank’s pursuit of its alleged target, in the spirit of Milton Friedman’s celebrated proposal of a constant growth rate for a monetary aggregate. Indeed, it can be viewed as a modern version of Friedman’s “k-percent rule” proposal, in which the variable that Friedman actually cared about stabilizing (the growth rate of nominal income) replaces the monetary aggregate that he proposed as a better proximate target, on the ground that the Fed had much more direct control over the money supply. On the one hand, the Fed’s ability to directly control broad monetary aggregates (the ones more directly related to nominal income in the way that Friedman assumed) can no longer be taken for granted, under current conditions; and on the other hand, modern methods of forecast targeting make a commitment to the pursuit of a target defined in terms of variables that are not under the short-run control of the central bank more credible. Under these circumstances, a case can be made that a nominal GDP target path would remain true to Friedman’s fundamental concerns.
At the same time Woodford criticized the current stop-and-go nature of the Fed’s quantitative easing policy. David Beckworth on Woodford’s findings:
(1) Quantitative Easing has not been very effective because the increase in monetary base it created is not expected to be permanent. If it were expected to be permanent, then the future price level and nominal income level would also be expected to permanently increase. Households and firms would respond to this development by increasing nominal spending today. The key point is to communicate some part of the monetary base increase will be permanent. See Bill Woolsey for more on this issue.
(2) The forward guidance provided by the Fed on the expected path of the target federal funds rate is doing little-to-nothing to restore robust economic growth. When the Fed lowers the expected path of the policy interest rate in its forecast is it because the Fed is truly adding monetary stimulus or is it because the Fed now expects a weaker economy? In the latter case, the Fed would be seen as simply maintaining the status quo of weak, anemic growth. See here for more on this point.
(3) Large scale asset purchases have not been effective in driving down long-term interest rates. If anything, it is the weak economy that explains most of the decline in yields. Exactly. While there are long-term structural changes (e.g.. aging, saving preferences in Asia, lower expected productivity growth) that may explain some of the decline, the fact that over the span of the crisis the 10-year treasury yield has gone from above 5.1% to 1.6% suggests a cyclical story. Simply, the ongoing expectation of weak economic growth in advanced economies is pushing down yields. The irony here is that the Fed, through its influence on global monetary conditions, could change economic expectations for advanced economies and raise long-term yields. In a sense, then, the Fed is responsible for the low interest rates just not in the way most observers think.
One question is to what degree has the sickly labor market been a function of the NGDP gap. Here is economist Mike Darda of MKM Partners:
The key feature of the chart is that the largest fall in NGDP against trend since 1938 has coincided almost perfectly with a plunge in the employment-to-population ratio, while the modest recovery in NGDP since 2009 has also coincided with a stabilization of the employment-to-population ratio. Thus, a stronger recovery in NGDP (or MV, if one prefers to think in Friedmanian terms) would be likely to help the labor market.
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