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December 13, 2012

Monetary policy: sailing deeper into uncharted waters

by Fathom Consulting.

This research note is provided courtesy of Fathom Consulting. All of the charts below are available in the Chartbook via Datastream. For more information on Fathom Consulting, or to trial our services, please visit us at

A number of prominent Central Bankers seem to be falling out of love with inflation targeting. On Tuesday, the current Governor of the Bank of Canada, and future Governor of the Bank of England, Mark Carney, gave a speech touting the possibility of targeting nominal GDP (NGDP). He appears to have changed his tone from a speech in February of this year where he offered some criticism of NGDP targeting. One wonders whether he has been influenced by his new boss, Chancellor George Osborne, who said today that he was “glad” that Mark Carney had raised the prospect of ending inflation targets and concentrating more on GDP. Mark Carney’s speech was soon followed by an unprecedented FOMC announcement that interest rate decisions will now be tied to the unemployment rate and inflation. Furthermore, the LDP party (the largest in opposition) in Japan have set out as part of their economic policy a three per cent nominal growth target. The global recovery has been disappointing while further monetary stimulus is made difficult by the zero lower bound. Perhaps as a consequence, there appears to be a potentially important, and globally coordinated shift taking place in monetary policy.

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The simplest way of implementing a target for the level of nominal GDP is to ensure that the rate of growth in nominal GDP averages some specified amount over a particular time period. As an illustration assume that, back in 2007, the MPC were given a remit to achieve an average 4 ½ per cent nominal GDP growth over the ten years to 2017. Since 2007 nominal GDP growth has averaged just 2.6% meaning that over the next 5 years nominal GDP would have to grow at 6.4%. Bygones are no longer bygones under this sort of monetary regime.

Under a policy that targets a specific level of nominal GDP, and under the assumption that the level is based on pre-crisis trends the attraction of an NGDP target is that the policymakers would have to loosen policy in the current climate. Under the current regime of inflation targeting, stimulus has ground to a halt in the UK as policymakers appear to have become disillusioned with QE and inflation has remained stubbornly above its target. By contrast, if they were forced to generate nominal growth of over 6%, the MPC would certainly be attempting more stimulus.

NGDP targeting is effectively a dual mandate for a Central Bank, as it implies they must focus on both inflation and real output. However it is a dual mandate that implies equal weights on both real output and inflation and, as such, is of a very restrictive form. While high real growth is almost always desirable, high inflation is not. Nominal growth of 4.5% where inflation is 4% and growth is 0.5% is clearly less desirable then inflation at 2% and growth at 2.5%. As the table highlights, it would always be unclear to what extent nominal growth would come through inflation or real GDP. This was a shortcoming that was highlighted by Mark Carney in his speech in February “NGDP-level targeting treats changes in overall prices and real activity as a package.” Furthermore, the current inflation-targeting regime does allow for flexibility if it is implemented properly: the MPC can “see through” periods of high inflation if the outlook for growth is weak and inflation is expected to come down to target in the medium term; witness the fact that they actually sanctioned Quantitative Easing with inflation close to 5% and bank rate at 0.5%.

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A nominal GDP levels target differs from the status quo in two key ways. First it treats real growth and inflation as both being equally desirable if nominal growth is below target, and equally undesirable if nominal growth exceeds the target. If anything, in the social welfare function, they are more like equal and opposite. Second it requires that bygones are no longer bygones. Assuming a credible policy, there are some advantages to knowing the price level in the future. It would allow people to plan for the future better by knowing where prices would be in the future. However, a path for the level of NGDP does not necessarily imply a level for prices. And the level of NGDP in itself is fairly meaningless.

The policy can also create instability, with policy focused on fighting past battles rather than looking to the future. The credibility of this policy would also depend on how the period in which the level of NGDP must be met is defined. UK macro policy makers have form here: Gordon Brown’s ‘Golden Rule’ for the current budget to be balanced over the business cycle became increasingly meaningless as the definition of the business cycle was continually changed, and in the end served to reduce the credibility of fiscal policy.

There is real potential for a loss of transparency and, with it, credibility, with this policy. The very idea of NGDP targeting is a reversal of the mainstream philosophy of monetary policy for the past 20 years: one target; one instrument; clearly defined rules guiding the use of that instrument. To quote Mark Carney, NGDP targeting does not “amount to a complete policy framework”, leaving a great deal to the discretion of the monetary authority. It seems that Mr Carney is announcing his intention to use his discretion (and that of the rest of the MPC, let us suppose) more aggressively to support growth than has been the case until now, even if doing so might conflict with the current rules relating to the inflation target.

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