Charles Goodhart might just be the best all-around monetary economist in the world, having made impressive contributions to both monetary theory and the history of monetary theory, to monetary history, and the history of monetary institutions, especially of central banking, and to the theory and, in his capacity as chief economist of the Bank of England, practice of monetary policy. So whenever Goodhart offers his views on monetary policy, it is a good idea to pay close attention to what he says. But if there is anything to be learned from the history of economics (and I daresay the history of any scientific discipline), it is that nobody ever gets it right all the time. It’s nice to have a reputation, but sadly reputation provides no protection from error.
In response to the recent buzz about targeting nominal GDP, Goodhart, emeritus professor at the London School of Economics and an adviser to Morgan Stanley along with two Morgan Stanley economists, Jonathan Ashworth and Melanie Baker, just published a critique of a recent speech by Mark Carney, Governor-elect of the Bank of England, in which Carney seemed to endorse targeting the level of nominal GDP (hereinafter NGDPLT). (See also Marcus Nunes’s excellent post about Goodhart et al.) Goodhart et al. have two basic complaints about NGDPLT. The first one is that our choice of an initial target level (i.e., do we think that current NGDP is now at its target or away from its target and if so by how much) and of the prescribed growth in the target level over time would itself create destabilizing uncertainty in the process of changing to an NGDPLT monetary regime. The key distinction between a level target and a growth-rate target is that the former requires a subsequent compensatory adjustment for any deviation from the target while the latter requires no such adjustment for a deviation from the target. Because deviations will occur under any targeting regime, Goodhart et al. worry that the compensatory adjustments required by NGDPLT could trigger destabilizing gyrations in NGDP growth, especially if expectations, as they think likely, became unanchored.
This concern seems easily enough handled if the monetary authority is given say a 1-1.5% band around its actual target within which to operate. Inevitable variations around the target would not automatically require an immediate rapid compensatory adjustment. As long as the monetary authority remained tolerably close to its target, it would not be compelled to make a sharp policy adjustment. A good driver does not always drive down the middle of his side of the road, the driver uses all the space available to avoid having to make an abrupt changes in the direction in which the car is headed. The same principle would govern the decisions of a skillful monetary authority.
Another concern of Goodhart et al. is that the choice of the target growth rate of NGDP depends on how much real growth,we think the economy is capable of. If real growth of 3% a year is possible, then the corresponding NGDP level target depends on how much inflation policy makers believe necessary to achieve that real GDP growth rate. If the “correct” rate of inflation is about 2%, then the targeted level of NGDP should grow at 5% a year. But Goodhart et al. are worried that achievable growth may be declining. If so, NGDPLT at 5% a year will imply more than 2% annual inflation.
Effectively, any overestimation of the sustainable real rate of growth, and such overestimation is all too likely, could force an MPC [monetary policy committee], subject to a level nominal GDP target, to soon have to aim for a significantly higher rate of inflation. Is that really what is now wanted? Bring back the stagflation of the 1970s; all is forgiven?
With all due respect, I find this concern greatly overblown. Even if the expectation of 3% real growth is wildly optimistic, say 2% too high, a 5% NGDP growth path would imply only 4% inflation. That might be too high a rate for Goodhart’s taste, or mine for that matter, but it would be a far cry from the 1970s, when inflation was often in the double-digits. Paul Volcker achieved legendary status in the annals of central banking by bringing the US rate of inflation down to 3.5 to 4%, so one needs to maintain some sense of proportion in these discussions.
Finally, Goodhart et al. invoke the Phillips Curve.
[A]n NGDP target would appear to run counter to the previously accepted tenets of monetary theory. Perhaps the main claim of monetary economics, as persistently argued by Friedman, and the main reason for having an independent Central Bank, is that over the medium and longer term monetary forces influence only monetary variables. Other real (e.g. supply-side) factors determine growth; the long-run Phillips curve is vertical. Do those advocating a nominal GDP target now deny that? Do they really believe that faster inflation now will generate a faster, sustainable, medium- and longer-term growth rate?
While it is certainly undeniable that Friedman showed, as, in truth, many others had before him, that, for an economy in approximate full-employment equilibrium, increased inflation cannot permanently reduce unemployment, it is far from obvious (to indulge in bit of British understatement) that we are now in a state of full-employment equilibrium. If the economy is not now in full-employment equilibrium, the idea that monetary-neutrality propositions about money influencing only monetary, but not real, variables in the medium and longer term are of no relevance to policy. Those advocating a nominal GDP target need not deny that the long-run Phillips Curve is vertical, though, as I have argued previously (here, here, and here) the proposition that the long-run Phillips Curve is vertical is very far from being the natural law that Goodhart and many others seem to regard it as. And if Goodhart et al. believe that we in fact are in a state of full-employment equilibrium, then they ought to say so forthrightly, and they ought to make an argument to justify that far from obvious characterization of the current state of affairs.
Having said all that, I do have some sympathy with the following point made by Goodhart et al.
Given our uncertainty about sustainable growth, an NGDP target also has the obvious disadvantage that future certainty about inflation becomes much less than under an inflation (or price level) target. In order to estimate medium- and longer-term inflation rates, one has first to take some view about the likely sustainable trends in future real output. The latter is very difficult to do at the best of times, and the present is not the best of times. So shifting from an inflation to a nominal GDP growth target is likely to have the effect of raising uncertainty about future inflation and weakening the anchoring effect on expectations of the inflation target.
That is one reason why in my book Free Banking and Monetary Reform, I advocated Earl Thompson’s proposal for a labor standard aimed at stabilizing average wages (or, more precisely, average expected wages). But if you stabilize wages, and productivity is falling, then prices must rise. That’s just a matter of arithmetic. But there is no reason why the macroeconomically optimal rate of inflation should be invariant with respect to the rate of technological progress.
HT: Bill Woolsey