Sunday, June 30, 2013

Why Nominal GDP Targeting Solves the Credibility Problem

Monetary easing at the zero lower bound seems to work in practice. But does it work in theory?

In his recent BIS speech, Rajan argues that monetary policy at the zero lower bound requires an impossible commitment. For the Fed to get real rates low enough for the economy to "lift-off", the only option is to raise expectations of future inflation. But what happens when that future arrives? Now that the economy has escaped the zero lower bound, the Fed is tempted to renege and stick to the original inflation target. Market participants, knowing this, then refuse to believe the original commitment, leaving the Fed stuck.

The same argument was made in reverse to explain why the Fed could not escape the high inflation equilibrium of the 1970's. As argued by Barro and Gordon, the Fed declares that it wants low inflation. If this is credible, then agents lower their expectations of inflation. However, this tempts the Fed into actually delivering high inflation to exploit the Philips curve relation and lower unemployment. As a result, the Fed is stuck at high inflation.

But the Fed escaped. The last release of the PCE price index came in at just 1.0% year over year, suggests that, if anything, the Fed lowered inflation too much. How did policy do this? In the case of moving from high inflation to low inflation, the solution was simple: adopt an inflation target. If the Fed only has to keep inflation from deviating from a target, then of course it will not cheat with any kind of surprise inflation. This kind of target can also be self reinforcing through a reputation mechanism, as the Fed knows that if it cheats now it will hurt more in the future. This removes the temptation to renege as unemployment deviations no longer matter. In the end, the Fed was successful. It managed to lower inflation from around 8% in the 1970's to the 2% levels we see today.

The target is just as important today. If the entire goal is to keep inflation at 2%, then of course there can be no commitment to forward guidance! But that is a criticism of inflation targeting, not forward guidance. Therefore the Fed needs to change its policy target. If the Fed decides its operating procedure no longer is to keep inflation at 2%, but rather to keep nominal GDP on a 5% trend, this drastically changes the perception of what is credible. The Fed no longer needs to "credibly promise to be irresponsible" -- it can just change the definition of responsibility.

If it seems magical that the Fed can change this definition so easily, it's because the loss functions that underpin these models of time inconsistency are arbitrary. In the Barro and Gordon case, the reason low inflation was time inconsistent was because unemployment deviations were included. Once the Fed ignored unemployment, its actions were time consistent. In the current forward guidance case, the reason high inflation is inconsistent is because the inflation rate is in the loss function. Therefore replacing inflation with a nominal GDP term would solve the time inconsistency problem now. The Fed gets to determine these costs. With the right loss function, credible policy becomes almost obvious.

The government can take steps towards this in many different ways. On the Fed side, they could come out with announcements saying that they are more concerned about stabilizing certain level variables -- for example nominal GDP. This would show that the Fed's loss function is changing, and therefore the expected policy adjusts. On the congressional side, they could pass a law that defines the dual mandate in terms of a nominal GDP target. This institutional reform would make Fed commitments to low future rates credible and help pull them out of the zero lower bound.

When nominal GDP targeting is cast as a framework for making future paths of interest rates credible, the implementation details of a nominal GDP target also become self evident. It's no longer a "whatever it takes" target, rather it becomes a template for adjusting the nominal interest rate. Raise the policy rate if nominal GDP is above trend, lower the rate if it's below. And if nominal GDP is so far below trend that your interest rate is stuck at zero, then provide forward guidance that the interest rate will be at zero until nominal GDP normalizes. Even though this is about future policy, there is no commitment problem. The promise is already optimal.

Therefore, nominal GDP target can make policy on the monetary instrument even more rule based. A well-defined target may make unconventional policies such as quantitative easing unnecessary -- forward guidance would be able to deliver similar results. As evidence, the recent whispers of Fed tapering have shown up most strongly in the forecasts of future interest rates. While this might seem peculiar because the Fed has not said anything about future rates, it is natural if QE is seen as a signal of the Fed's stance on future rates. Gavyn Davies notes:
There is evidence that this signalling effect of Fed balance sheet changes might be very powerful. If the Fed is not willing to “put its money where its mouth is” by buying bonds, then the market might take its promises to hold short rates at zero less seriously than before. According to this recent research by the San Francisco Fed, it is possible that a sizeable proportion of the total effect of QE on bond yields came from these signalling effects rather than the portfolio balance effects which have usually been emphasised by the central banks.
If this is the case, then the credibility effect of a nominal GDP target on forward guidance would be enough. Long rates across the board -- MBS, treasury, corporate debt -- could be lowered merely by the expected future path of rates without direct Fed intervention into those markets. Note that because inflation targeting would suffer from credibility issues when it comes to forward guidance, it can get stuck with a persistently negative output gap. This may end up forcing policy makers to deviate from the rule. So surprisingly, nominal GDP targeting would actually be more rule-based as a result.

Credibility is no problem at the zero lower bound. A nominal GDP target would go a long ways towards securing it -- in both practice and theory.


  1. YW
    Great post. Why doesn´t Mark Carney argue along those lines?

  2. Thanks. I'm certain these points on credibility have been made before, but I haven't seen it cast in terms of loss functions before. I thought I could make a contribution on that point.

  3. You certainly did. I took the liberty to link over at my blog as "A post not to be missed (under any circumstance).

    Evan was asking us to write on the topic given with Carney in mind. This was the best argument for him.

  4. “And if nominal GDP is so far below trend that you[r] interest rate is stuck at zero, then provide forward guidance that the interest rate will be at zero until nominal GDP normalizes. Even though this is about future policy, there is no commitment problem. The promise is already optimal.” The point is well taken, but note that fulfilling this promise may be insufficient: QE might be needed as well.

    Another objection to NGDP targeting is that NGDP is hard to measure, so that measurements of recent-past NGDP may come in with surprising numbers, which may later be revised in unexpected ways. But the Fed should target not the actual level NGDP but the level estimated for future NGDP, one or two years into the future. The slogan: “Target the forecast.”

  5. Yes. The analogy I like to make is between central banks and judges. On the face of it, judges face a big credibility problem: "The murder has already been committed; the victim is dead, and there's no point in creating a lot of additional costs to society by imprisoning the murderer, so I will let the murderer go free." But in practice judges like to enforce the law, and if the government wants to change judges preferences, it just changes the law.

  6. Anyone in the "know" want to hazard a guess on the possibility of the Fed actually establishing an NGDP target? For all the positive effects that establishing this target could have on a "real" economy, it seems like it would generate uncertainty about the inflation rate for lenders. Don't banks still pretty much dictate monetary policy to the Fed?

    Great idea, though - it just seems much too bold for current policymakers.

    1. I'm not sure if a nominal GDP targeting regime would be that bad for lenders. There has been a lot of work done by other bloggers on how nominal GDP targeting insures both lenders and borrowers in a counter-cyclical fashion, so nominal GDP targeting would help deliver a result closer to what amounts to a coordinated haircut among creditors. Of course, I certainly hope that Fed policy is not just dictated by a handful of banks, but I'm not sure if it matters too much in the case of monetary policy. Now capital requirements on the other hand...well, that's just a different story.