October 29, 2011


Dear Ben: It's Time for Your Volcker Moment (CHRISTINA D. ROMER, 10/29/11, NY Times)

Nominal G.D.P. is just a technical term for the dollar value of everything we produce. It is total output (real G.D.P.) times the current prices we pay. Adopting this target would mean that the Fed is making a commitment to keep nominal G.D.P. on a sensible path.

More specifically, normal output growth for our economy is about 2 1/2 percent a year, and the Fed believes that 2 percent inflation is appropriate. So a reasonable target for nominal G.D.P. growth is around 4 1/2 percent.

Economic research showed years ago that targeting nominal G.D.P. has important advantages. But in the 1990s, many central banks adopted inflation targeting, a simpler alternative. As distress over the dismal state of the economy has grown, however, many economists have returned to the logic of targeting nominal G.D.P.

It would work like this: The Fed would start from some normal year -- like 2007 -- and say that nominal G.D.P. should have grown at 4 1/2 percent annually since then, and should keep growing at that pace. Because of the recession and the unusually low inflation in 2009 and 2010, nominal G.D.P. today is about 10 percent below that path. Adopting nominal G.D.P. targeting commits the Fed to eliminating this gap.

HOW would this help to heal the economy? Like the Volcker money target, it would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth.

Such expectations could increase spending and growth today: Consumers who are more certain that they'll have a job next year would be less hesitant to spend, and companies that believe sales will be rising would be more likely to invest.

Another possible effect is a temporary climb in inflation expectations. Ordinarily, this would be undesirable. But in the current situation, where nominal interest rates are constrained because they can't go below zero, a small increase in expected inflation could be helpful. It would lower real borrowing costs, and encourage spending on big-ticket items like cars, homes and business equipment.

Even if we went through a time of slightly elevated inflation, the Fed shouldn't lose credibility as a guardian of price stability. That's because once the economy returned to the target path, Fed policy -- a commitment to ensuring nominal G.D.P. growth of 4 1/2 percent -- would restrain inflation.

What Is NGDP? ( Kelly Evans, 10/27/11, WSJ)

 Hence calls, which are growing ever louder, for an entirely new, different kind of target: nominal GDP. This is something Scott Sumner, an economist at Bentley University whose views have gained prominence through his blog, TheMoneyIllusion, has been pushing for two decades. His support base among academics lately has been growing. And perhaps most significant, since it suggests the Fed might actually be open to such an idea, is that Goldman Sachs economists have just endorsed the idea as well.

The version which Goldman puts forth, building on the ideas of Sumner and others, is that the Fed ought to aim for a specific level of NGDP which would put the economy back on the trend it was prior to the recession; to close, in other words, the current gap between the economy today and where econometric models suggest the economy should be. This is no small gap; Goldman estimates the shortfall, as of the second quarter, is roughly 10%. To most quickly close this gap, Goldman estimates the Fed would need to roughly double its balance sheet to $5 trillion and keep interest rates at zero through at least 2016.

The beauty of the NGDP target, as proponents see it, is that it doesn't differentiate between inflation and real GDP. So it doesn't matter whether the gap is closed by three parts inflation and one part real GDP or one part inflation and three parts real GDP. The point is that the gap gets closed, because the Fed is able to be as aggressive as it needs to be, and the economy avoids a prolonged slump and chronically high unemployment a la the Great Depression. And by targeting NGDP, or a stated goal for the total size of the economy, instead of a 3% or 5% inflation rate, the Fed is better able to avoid the backlash that might otherwise undermine its ability to achieve said objective.

Folks can be forgiven the slowness with which they've come to accept and reckon with global structural deflation, but it is time to start reckoning.

Posted by at October 29, 2011 5:44 PM

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