Why nominal income won't catch on
Swirling debate on central bank targets
by David Marsh and Bhavin Patel
Fri 2 Sep 2016
Intellectual fashions for targeting and measuring central banks’ performance circulate in seemingly endless cycles of political and economic fashion and acceptability. The latest fad, now back in vogue, is the idea that central banks, facing up to the limitations of a 30-year regime of inflation-targeting, should shift to focusing on nominal GDP as their main navigational device.
The NGDP (also known as ‘money GDP’ or ‘nominal income’) theme will remain a topic for pondering in central banking parlours for years to come. Yet there are good reasons for thinking that the nominal GDP framework – which has been sporadically aired in academic and policy circles for at least 40 years – will remain where it habitually has been: on the drawing board.
Establishing a concept linking both the inflation rate and the real level of economic activity (which together add up to nominal GDP) would, according to enthusiasts, demonstrate that central banks pay attention to both prices and employment. These twin aims are already present in the Federal Reserve’s dual mandate, but are not specifically recorded in the policy setting of most other central banks, including the European Central Bank and the Bank of England.
Adopting nominal GDP would allow central banks both to tolerate a higher inflation rate during periods of recession and to run higher interest rates than has been the case in past years. This would afford more leeway to cut rates during a time (such as the present) of economic slowdown and thus escape the obstacle of the ‘zero bound’ in rate-setting, especially the hazards of negative interest rates confronting Europe and Japan.
John Williams, president of the San Francisco Fed, has suggested raising the Fed's 2% inflation goal, or replacing inflation-targeting with a nominal GDP approach, to give the Fed more scope to lower interest rates in downturns. But he emphasised that both steps could have costs.
In February 2010, when the drawbacks of zero interest rates were already putting frowns on central bankers’ faces, Olivier Blanchard, then chief economist at the International Monetary Fund, proposed increasing the inflation target to 4%.
Higher average inflation and thus higher average nominal interest rates before the crisis would have provided more room for monetary policy to be eased subsequently, mitigating the ensuing deterioration of fiscal positions, Blanchard pointed out.
Logical enough. But the recommendation was widely seen as a distraction, and never advanced up the policy-making agenda.
In her speech at the Jackson Hole monetary conference on 26 August, Janet Yellen, the Federal Reserve chair, gave a nod in the direction of methods such as an NGDP approach, which she called ‘important subjects for research’. Yellen underlined that the Fed was not actively considering such ideas for an operating framework. But she did point out how lower interest rates might impair the Fed’s recession-fighting capacity.
Yellen pointed to the marked decline over the past decade in the long-run neutral real rate of interest – the inflation-adjusted short-term interest rate consistent with maintaining average output. A future average federal funds rate of about 3% places an arithmetical constraint on Fed firepower, since it cut rates by an average of 5.5 percentage points in the past nine recessions – implying a shortfall of about 2.5 percentage points for dealing with an average-sized recession.
Britain offers a case study in the swirling nature of the policy debate. Since the abandonment of the Bretton Woods fixed exchange rate system in 1971-73, the UK has experimented with a wide sweep of policy regimes. These range from focusing on Keynesian overall demand parameters and various formulae for the money supply, to overt and covert exchange rate objectives – including the 23-month spell inside the exchange rate mechanism in 1990-92 and, since then, different forms of inflation-targeting.
One of the principal objections to using nominal GDP as a policy aim surrounds the frequent revisions of data, often for definitional reasons.
Yet deliberations on NGDP will not go away quickly. Charlie Bean, then deputy governor of the Bank of England, pointed out in 2013 how economist James Meade advanced the nominal income theme in his 1977 Nobel Prize lecture. As Bean pointed out, UK nominal income growth has been fairly stable at around 5% a year since 1999 (see Chart below – click here to enlarge), with the notable exceptions of the 2008-09 recession and the present low-inflation period, when nominal GDP growth has been nearer 2-3%.
These deviations from the long-run average graphically underline the difficulty of using the nominal income method as a target for policy-making, rather than simply as a backward-looking check on the success or otherwise of these policies.
It is hard to imagine how the Bank of England, or any other central bank, would have reacted differently to the 2008 financial crisis had it been using a nominal income benchmark rather than its present set of policy tools. Central banks in advanced economies have faced grave problems in sticking to a 2% inflation target. The difficulties of meeting a higher inflation goal as part of a reaction to lower growth would have been still greater – as would have been the public criticism of their failure to meet objectives.
David Marsh is Managing Director and Bhavin Patel is Research Assistant at OMFIF.
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