Central banks lack both the power and the knowledge needed to deliver stable growth.
Canadian central bank chief Mark Carney, who will become governor of the Bank of England in June, caused a stir on both sides of the Atlantic when he appeared to endorse a monetary policy based on nominal gross domestic product (NGDP) targeting—a new monetary policy framework. A fresh approach to the current policy, which has manifestly failed to guarantee macroeconomic stability, is certainly long overdue. But could NGDP targeting have really prevented the financial meltdown and the ensuing recession as its advocates claim?
NGDP targeting does have advantages over a regime that requires central banks to adjust policy in response to consumer price inflation—the model currently used by many central banks world over, including the Bank of England and the Bank of Canada. If inflation is high, banks tighten monetary policy and if low, they loosen it. But the consumer price indices that are used to measure inflation are easily swayed by factors beyond monetary policy like tax changes, exchange rates, or the availability of cheap imported goods. Moreover, they frequently blind central bankers to the formation of dangerous and destabilizing housing and asset bubbles—both of which were major players in the recent crisis. And just as inflation targets may obscure a coming crisis, they may not be a good guide to action once trouble arrives given that significant monetary disruptions can occur without immediate changes in the price level.
The idea behind the proposed alternative is relatively simple: central banks should use the tools at their disposal—interest rates, quantitative easing and the like—to deliver a stable NGDP growth rate, not simply target inflation. The most commonly cited target is 5 percent, equivalent to the sum of real growth (which is expected to run at 3 percent a year in normal times) and inflation (which is expected to run at 2 percent). It is a more inclusive target and a more forward-looking one: rather than reacting to the last measurable quarter’s inflation statistics, central banks should target expectations of future growth.
If NGDP growth falls or is expected to fall below 5 percent, the central bank would loosen monetary policy. If NGDP grows too fast, the central bank would tighten monetary policy. Notice that this implies a higher tolerance of price rises during a slump (when the real growth component of NGDP will be lower), coupled with a harder line on inflation during a boom (when the real growth component of NGDP will be higher). That suggests that NGDP targeting would produce a counter-cyclical monetary policy, making it a more effective economic stabilizer than inflation targeting. Or so its advocates suggest.
They also tend to propose level targeting, which requires central banks to make up for past NGDP under- or overshoots in subsequent years. That means that if NGDP growth is below 5 percent in Year 1, monetary policy should aim to bring it above 5 percent until the lost ground is made up, and vice-versa. Traditional targeting regimes are too content to let bygones be bygones, NGDP targeters say, and that allows significant slippage over time—another deficiency that shifting to a new monetary framework could rectify.
The irony of this is that some say the Bank of England—Mark Carney’s future home—is already pursuing an NGDP target. The Financial Times reported over a year ago that “[some Bank of England insiders] are open that the Bank is really targeting nominal gross domestic product growth of about 5 per cent a year.” Others have pointed out that the Bank of England’s policy decisions only make sense if you assume they’re doing something other than targeting 2 percent inflation—the primary objective legislation obliges them to pursue. After all, Britain’s rate of inflation has been consistently above that 2 percent target since December 2009. The Bank of England even announced £75 billion of additional quantitative easing when inflation stood at 5 percent—hardly the act of a central bank trying to rein in above-target inflation.
But just because the Bank of England opened the monetary spigots doesn’t mean it could make the money flow into the broader economy. Why? Because many banks seem to have used the money to recapitalize themselves, rather than offer more loans. Indeed, M4, the broad money aggregate, has remained sluggish even as the Bank of England has slashed interest rates and printed money.
Even if the Bank could overcome this problem, there’s no guarantee the added money would help rather than hurt the economy. The boom years have left Britain with a structural over-reliance on the financial industry, housing, and government spending—none of which are likely to be engines of growth any time soon. Thus a looser monetary policy might well prop up an unsustainable status quo in three credit-reliant sectors, preventing the rebalancing that is needed for robust growth. The big problem with NGDP targeting is that it assumes the central bank has power over something that it doesn’t.
Moreover, even if one accepts that a central bank is capable of hitting its growth target, that leaves open the question as to what target it should aim for. And it is not possible to know in advance what the “correct” rate of NGDP growth should be. The central bank can base its target on past growth, but even educated guesses can’t ultimately overcome this “knowledge problem.”
As London-based economist Anthony J. Evans has pointed out, if you consider 1997, the year that Bank of England began targeting inflation as your base year, and assume a 5 percent annual NGDP growth target, then you would believe that British monetary policy in the run up to the crash was more-or-less fine: NGDP growth stayed close to 5 percent throughout the “great moderation.” You would also believe that we are now significantly below the “correct” level of NGDP, and should fire up the printing presses to bring things up to scratch. If, on the other hand, you assume a 4.5 percent target since 1997, you would think that monetary policy was too expansionary in the run up to the crash, and that NGDP growth has already returned to trend—hence, time for monetary policy to “normalize”. The point here is not that 5 percent is the wrong target, or that 4.5 percent is the right one. The point is that even a small targeting error can have massive policy implications.
None of this is to deny that NGDP targeting could be an improvement over inflation targeting. But it is doubtful that it would work as effectively as its advocates suggest. Central banks lack both the power and the knowledge needed to deliver stable growth instead of distorting the economy. In fact, it’s not clear that any policy tool can overcome these problems.