Where the Fed Stands on Monetary Policy

The decision to embark on QE3 was right, in my view, if overdue. But perhaps I'm not the only one who's uncertain which way the Fed's strategy is evolving. Is it guided by a coherent account of how monetary policy should be conducted, and if so what exactly is that account?

Scott Sumner, the indispensable scholar-blogger who's been campaigning for nominal GDP targeting, sees the Fed's move as a step in that direction. My Atlantic colleague Derek Thompson, getting a little carried away, anoints Sumner "the blogger who saved the economy"--meaning (a) the Fed has just adopted his way of thinking and (b) it will work like a charm. The NGDP approach got another boost at the Jackson Hole central bankers' conference, when Michael Woodford, an eminent (many would say today's pre-eminent) monetary theorist, endorsed it.

So is Bernanke now targeting NGDP--and would that be a good thing? My short answers are "no" and "it depends". I'll get to my longer answers in a second, but first a word of warning. I'm still digesting Woodford's Jackson Hole paper, but some important questions are getting muddled in the way his paper has been discussed. The NGDP or not-NGDP frame isn't helping to clarify the situation. These are my notes on thinking this through. If you're aren't much interested in monetary policy, I'd definitely stop reading here.

I come to this issue as a money-GDP man myself (that's what Brits called NGDP when they were debating the subject in the 1980s, following the work of James Meade, reintroduced to policy circles mainly by Samuel Brittan of the Financial Times). But the standard case for money-GDP targeting back then was not the case being pressed today.

Back then, a target for growth in money-GDP was seen as an improvement over the prevailing targets for growth in the money supply. Why? Because the hitherto-stable relationship between money supply and demand (nominal income, money-GDP) had broken down. Since demand was the variable the central bank was really trying to guide, forget the money-multiplier and just set the policy target directly. Essentially, that was the idea. Money-GDP had other advantages. What mattered most, in my view, was that it would make policy easier to explain. Also, as compared to the alternative of setting an inflation target--which is the route central banking subsequently took--a target for growth in money-GDP has the advantage of accommodating certain kinds of economic shock more comfortably.

This short piece by Bennett McCallum, a leading advocate of nominal income targeting (as he called it) in the 1980s and after, gives a good concise summary.

This earlier discussion mostly revolved around setting a target for growth in money-GDP. The new NGDP advocates tend to argue for targeting a level. It's an important difference. On Woodford's view, the choice of level (that is, multi-year path) over year-by-year rate of change matters more than whether you choose NGDP or any of several plausible alternative measures of demand. There'd be less confusion if the main issue in contention in today's debate were understood not as NGDP vs not-NGDP, but as nominal-path-targeting vs nominal-growth-targeting.

This emerges clearly in Woodford's paper. In his model, the ideal target is the "output-gap-adjusted price level"--ie, a price index adjusted by a weighted measure of the gap between current output and full-employment output. He notes that there are some practical problems with this target, and sees a target path for NGDP as a good alternative. In explaining this, he makes points familiar to those engaged in the earlier debate.

Essentially, the nominal GDP target path represents a compromise between the aspiration to choose a target that would achieve an ideal equilibrium if correctly understood and the need to pick a target that can be widely understood and can be implemented in a way that allows for verification... Indeed, it can be viewed as a modern version of Friedman's "k-percent rule" proposal, in which the variable that Friedman actually cared about stabilizing (the growth rate of nominal income) replaces the monetary aggregate... Under [today's] circumstances, a case can be made that a nominal GDP target path would remain true to Friedman's fundamental concerns.

However, aiming to stabilize growth in nominal income isn't the same as getting nominal income back to a path it has deviated from--perhaps (as now) by a long way. Whether the central bank should promise to do that is a question to which Woodford's model gives a clear answer.

In Woodford's model, under the exceptional circumstance of interest rates at the zero bound, the central bank should commit itself to get gap-adjusted prices back to the target path. This path, by the way, can't be fixed in advance: In principle, it continually shifts up, so long as the shortfalls induced by the zero bound persist. But that's a refinement. The critical thing in Woodford's view is to rule out "letting the target path shift down in response to persistent target shortfalls during the period of the binding lower bound" [original emphasis]. There's to be no downward base drift--no forbearance of undershooting. All that lost ground in lower-than-desired demand is going to be made up later, the central bank promises, even if it means a period of faster-than-desired inflation.

The whole point of this rule, as Woodward emphasizes, is that it's backward-looking and time-inconsistent. In other words, because of where the economy's been, the policy will be maintained beyond the point at which it stops making sense on a purely forward-looking basis. This is a vital point that many people have failed to grasp.

[O]ne wants people to understand that the central bank's policy will be history-dependent in a particular way -- it will behave differently than it usually would, under the conditions prevailing later, simply because of the binding constraint [the zero bound] in the past. [original emphasis]

I take it for granted that Woodford's approach has all the theoretical virtues he claims for it. If an economy with interest rates at the zero bound expects stimulus to be maintained until money-GDP is back on the pre-recession path--maintained, that is, even if inflation has risen to its desired rate and the output gap has gone--then it's going to be better off overall. Again:

This means that even once financial conditions have normalized, so that it would be possible for the central bank to achieve both its inflation target and a zero output gap from then onward (at a normal level of the policy rate), it might be necessary to keep interest rates low for somewhat longer, in order to raise the gap-adjusted price level to the target path.

It's a trade-off: The promised tolerance of excess inflation in future delivers stimulus now, when it's needed. The overshoot in inflation is the price you pay for that superior outcome. But think about the challenge this poses to the central bank. It has to keep the pedal to the floor with inflation at or above its normal rate, even if this is no longer necessary to get the economy to full employment. This commitment to subsequently inappropriate policy is a tall order. According to Woodford, this is where an NGDP-path target comes in. It's a way to explain what the Fed intends and why.

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