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Gavyn Davies has a new column
where he responds to Michael Woodford’s call for a NGDP level target. 
Davies is always a good read, but this time he raises some concerns
about NGDP level targeting that are unwarranted.  He claims  that the
Fed may be uncomfortable with a NGDP level target because it might
unmoore inflation expectations, it might be seen as time-inconsistent
with the Fed’s long-run objectives, and finally it may be too late to
return NGDP to its pre-crisis trend.  While understandable, the first
two concerns are without merit under NGDP level targeting.  This
approach to monetary policy actually anchors long-run inflation
expectations and provides a credible way to commit.  The last concern
has more merit, but even here it is not a clear-cut case. Let’s look at
each of these concerns in turn.

Here is Davies on the first concern :

[T]here is one
obvious reason why the Fed might feel uncomfortable with some aspects of
the Woodford approach: it might unhinge inflation expectations from the
2 per cent anchor which has been in place for more than a decade, and
which was so costly to establish in the 1980s and 1990s… And greater uncertainty about the
future rate of inflation could damage the real economy.

This same concern was raised earlier by John Cochrane in his response to Michael Woodford’s speech.  As I noted in my reply
to Cochrane, this concern assumes that the temporarily higher inflation
would be viewed as a discretionary, ad-hoc surge in inflation.  But
that is  not the case under a NGDP level target:

A level target anchors long-run
inflation expectations, but allows for temporary catch-up growth or
contraction in NGDP so that past misses in aggregate nominal expenditure
growth do not cause NGDP to permanently deviate from its targeted
path.  Woodford notes that currently NGDP is anywhere from 10-15% below
its trend (and thus expected) growth path.  Any increase in inflation
under this target, therefore, would not be some ad-hoc temporary
increase but part of a systematic approach that would return NGDP to its
trend. 

The point is that these temporary
increases (or declines in the case of a boom) in inflation would be seen
as part of a systematic response of monetary policy that simply
returned nominal incomes to some stable growth path.   And the expected
stable nominal income path would anchor long-run inflation expectations
as I noted in my reply to Cochrane:

 

[S]uch a commitment would accordingly require pursuit of nominal GDP
growth well
above the intended long-run trend rate for a few years in order to close
this gap. At
the same time, such a commitment would clearly bound the amount of
excess nominal income growth that would be allowed, at a level
consistent with the Fed’s announced long-runt target for inflation.

A
second reason for possible Fed concern is more institutional in nature,
concerning the long term credibility of the Fed. Professor Woodford’s
recommended target framework risks being seen as time inconsistent. The
optimal policy for the Fed today is not optimal for a future FOMC to
pursue, once the economy has recovered, and inflation is above 2 per
cent. The pressure on the future FOMC to renege would be enormous. The
markets know this today, so would the commitment to the NGDP framework
be credible in the first place?

No,
under a NGDP level target any temporary easing (or tightening) in the
short-run is very time consistent, because it is returning nominal
income to the Fed’s long-run growth path target.  That’s kind of the
point of level targeting, it coordinates short-run policy
moves with long-run policy objectives. Under a NGDP level target,
everyone understands the “catch-up” nominal income growth is temporary
and tied to an objective.  The public would also understand that once
the target path was hit, nominal income growth would slow to trend. 
They would come to expect it.  In other words, there are no
inconsistencies between the short-run and long-run.

Moreover,
a NGDP level target would create so much credibility that the markets
would end up doing the heavy lifting.  If the markets know the Fed will
do whatever is necessary (i.e. buy or sale as many assets as needed) to
return nominal income to its target growth path, than this expectation
causes the public to start adjusting spending and investment choices
today.  For example, let’s say the Fed announced that QE3 was now aimed
at raising NGDP 10% to hit its pre-crisis trend and that it would start
buying every week enough securities to make sure that it happened.  This
would be a huge slap to the face of the market and cause a major
rebalancing of portfolios.  This rebalancing would create wealth
effects, improve balance sheets,and ultimately spur nominal spending. 
The Fed would not have to purchase that many securities.  Just the
threat of doing so would be sufficient.

Because
a NGDP level target would create such credibility and thereby improve
management of expectations, this approach would also  tend to
automatically reduce the occurrence of AD
shocks in the first place.  Michael Woodford agrees:

A commitment not to let the target path shift down means that, to the
extent that the target path is undershot during the period of a binding
lower bound for the policy rate, this automatically justifies
anticipation of a (temporarily) more expansionary policy later, which
anticipation should reduce the incentives for price cuts and spending
cutbacks earlier, and so should tend to limit the degree of the
undershooting. Such a commitment also avoids some of the common
objections to the simple Krugman (1998) proposal that the central bank
target a higher rate of inflation when the zero lower bound constrains
policy.

Gavyn
Davies’ final concern is that the price level, one component of NGDP,
is already back to trend and that the trend path of potential real GDP
has declined since the crisis. Therefore, returning NGDP to trend would
ultimately result in an permanently higher price level path than
expected, since closing the real GDP gap would not suffice by itself to
close the NGDP gap.  That is a reasonable concern that others have
brought up before.  The problem with this concern is that it is based on
Davies’ estimation of a trend line.  Others, like Tim Duy,
have fitted lines that put the price level currently below its trend. 
Similarly, the decline in potential real GDP may prove to be temporary
once the economy starts roaring again, a point made by Mark Thoma.  If
so, then the closing the real GDP gap may suffice for closing the NGDP
gap.   Still, there is a lot of uncertainty over how much of the NGDP
gap can be closed. One simple solution suggested by Scott Sumner is to
set a slightly lower target growth path for NGDP than the pre-crisis
trend.  This concern, therefore, should not be a game changer for
whether the Fed adopts an explicit NGDP level target. 

Overall,
then, Gavyn Davies concerns about implementing a NGDP level target are
unwarranted.  If the Fed decided to follow an explicit NGDP level target
then inflation expectations should not become unanchored and
credibility should not be an issue.  Now one might reply that the Fed
could never really commit to a NGDP level target in the first place. 
That is a different argument and if true points to deeper problems at
the Fed that would affect the effectiveness of any targeting regime the
Fed adopted, not just a NGDP level target.  This too, however, could be
addressed by Congress changing the Fed mandate to NGDP level targeting.

P.S. Scott Sumner makes the overall best case for NGDP level targeting here. 

2012-10-05 23:03:55

Source: http://macromarketmusings.blogspot.com/2012/10/more-ngdp-targeting-concerns-gavin.html