Why now is the time for targeting the level of money GDP rather than inflation
Having inflation as the main target for monetary policy has looked broken for a long time now, as have dual mandate systems of targeting inflation and GDP growth (or the output gap). It looks even more broken in the current circumstances.
How can I say that? Firstly, in the UK I’ll point to the Office of Budget Responsibility (OBR) assessment that the output gap was more negative than -1% for 22 consecutive quarters from 2008Q4 to 2014Q1 then a further 10 quarters of a smaller negative output gap followed. That’s a very long time to have unemployment above its natural rate. Secondly, inflation-targeting looks broken because there are better options available. In particular, targeting a path for the level of money GDP (aka nominal GDP) looks like a far preferable option at the moment and I would give two big current reasons for this.
Firstly, committing to return to a levels path for money GDP gives certainty about the size of the (nominal) economic pie in the long-term, if not the composition. Nominal aggregates are what matter most to the functioning of asset markets. Equity prices, the most important driver of returns on funds saved for pensions and which have crashed recently, are the net present value of future nominal paths for returns. Debts are repaid out of nominal incomes and profits and lending decisions are made against future flows of incomes and profits. Under inflation-targeting, the future path of nominal incomes and profits is allowed to collapse when output is lost or price growth is under target, leaving high numbers of individuals and firms with debts they can’t pay. Looking at the 2005-2014 experience, would you rather individuals and firms pay their (nominal) debts using income and profits based on the dark blue line or the red line?
Secondly, targeting the level of money GDP is a great way of generating credible large expected negative real interest rates. Nominal interest rates can’t go negative and have to stop falling at the zero lower bound, but real interest rates, defined as nominal interest rates minus expected inflation, can go negative and potentially very significantly so. Again looking at UK data, there were some moderately large negative real interest rates delivered ex post, but not really in expectation, which is what matters.
Targeting the level of money GDP creates a powerful signal that either real GDP growth will recover back to its previous path or there will need to be inflation to replace lost GDP growth. In the chart above, this would have rapidly got to the point where firms and individuals were expecting an extra 12-13% cumulative rise in the price level above normal inflation, creating a powerful signal to start borrowing and spending. And the beauty of this lies in the fact that this would have pushed real GDP up so that kind of move in the price level doesn’t have to happen in practice.
Looking at the current situation, targeting the level of money GDP will almost certainly lead to a faster economic rebound once COVID-19 is beaten, meaning more jobs, more income and fewer bankruptcies than we would see with a slower recovery.
If you want to delve more into these issues then I would check out almost anything ever written by Scott Sumner. This is not a bad starting point.