The Federal Reserve is conducting a rare review of its monetary policy framework. In February, the Fed launched an ongoing listening tour with events nationwide. The central bank’s policy-making Federal Open Market Committee is slated in the first half of 2020 to report its findings on the strategy, tools and communications methods to best meet the Fed’s statutory dual mandate of maximum employment and price stability.
In the event of a major reform to the Fed’s policy framework, one option that has gained momentum in the economic community is nominal GDP (NGDP) level targeting, sometimes synonymously known as nominal income targeting.
Among monetary policy experts, Mercatus Center senior research fellow David Beckworth, host of the Macro Musings podcast, is a leading advocate for NGDP level targeting. He offers key points in his new special study, "Facts, Fears, and Functionality of NGDP Level Targeting: A Guide to a Popular Framework for Monetary Policy."
NGDP level targeting is:
- A dollar-denominated target. The framework stabilizes the dollar size of the US economy. This anchoring is accomplished by having the Fed target the level of total dollar spending in the economy, or nominal gross domestic product. Since every dollar spent becomes a dollar earned, this framework also stabilizes the dollar income size of the US economy.
- A growth-path target. The Fed’s current inflation-rate target does not require the central bank to make up for past mistakes, nor would a growth-rate target. But NGDP level targeting is a growth path target that would compel the Fed to make up for previous overshooting or undershooting of its targeted total dollar spending growth. This feature reduces the incentive for consumers and businesses to over- or underspend money in the first place, further stabilizing the economy.
- A velocity-adjusted money supply target. Velocity is the number of times money gets used. When there is an increase in velocity, as might happen after labor market flexibility reforms or a technological boost to productivity, monetary conditions will automatically tighten when the Fed slows money supply expansion to rein in the growth path of total dollar spending. If velocity declines – due to a tax hike or trade war, for example – monetary conditions would be loosened in the course of implementing NGDP level targeting. The stable growth path of nominal GDP can be seen as a see-saw: more velocity means less money supply, and less velocity means more money supply.
- A work-around to the supply shock problem. Unexpected swings in the productive capacity of an economy, such as a surge in energy prices, can cause temporary inflation. But the same supply shock reduces productive capacity, so a central bank tightening monetary policy is only further choking the economy. Conversely, a demand shock that boosts spending can fuel both economic activity and inflation, so monetary tightening is prudent. In practice, though, central banks struggle to identify which phenomenon is the source of inflation or deflation. Under an NGDP level targeting framework, monetary authorities are focused on stabilizing demand, without the distraction of the short-term inflation rate.
- A work-around to incomplete financial markets. In practice, not all future risks can be hedged in financial markets. NGDP level targeting tends to create countercyclical inflation, insuring debtors against painful deflation in recessions and reducing the inflation risk borne by creditors in good times.
- An anti-zero lower bound tool. Conventional monetary policy is struggling to deal with nominal short-term interest rates that have been persistently near or below zero since the 2008 crisis. NGDP level targeting does not necessarily allow more inflation, but tolerates more inflation flexibility over the business cycle. In particular, more inflation during a downturn would countercyclically ease real debt burdens when it’s needed most, and lift the natural interest rate off the zero lower bound better than inflexible inflation-rate targeting.
- A way to do rules-based monetary policy. Under a discretionary monetary policy, it’s easy to make promises but difficult to deliver, one example being the Fed’s current 2 percent inflation-rate target, which has rarely been met in the years since it was publicly declared. NGDP level targeting would provide a simple, nominal target that meets the definition of a rules-based policy.
Photo by Steve Heap