NGDP Targeting and the Public.

• Author: Binder, Carola
• Position: Nominal gross domestic product - Report

At the November 2011 Federal Open Market Committee (FOMC) meeting, the FOMC discussed the potential benefits of nominal gross domestic product (NGDP) targeting. A memo by staff economists suggested that NGDP targeting could result in improved inflation and unemployment outcomes under a variety of scenarios. Former Federal Reserve chairman Ben Bernanke recalls this discussion in his memoir about the financial crisis:

We considered the theoretical benefits of the approach, but also whether it was desirable, or even feasible, to switch to a new framework at a time of great economic uncertainty. After a lengthy discussion, the Committee firmly rejected the idea. I had been intrigued by the approach at first but came to share my colleagues' reservations about introducing it at that time. Nominal GDP targeting is complicated and would be very difficult to communicate to the public (as well as to Congress, which would have to be consulted) [Bernanke 2015: 517-18].

Since then, policymakers and others have continued to discuss whether NGDP targeting or other alternative targets could alleviate the constraint of the effective lower bound on nominal interest rates, improve policy robustness, promote greater financial stability, or even address distributional concerns (Koenig 2010; Billi 2014; Azariadis et al. 2015; Garin, Lester, and Sims 2016). (1) For example, Romer (2011) argues that targeting a path for the level of NGDP (NGDP level targeting, or NGDPLT) would encourage the Fed to act more aggressively in downturns, boosting confidence and expectations of future inflation. Temporarily higher expected inflation in downturns would stimulate spending and employment, and inflation expectations should decline as the economy approaches its target path.

NGDPLT could improve not only macroeconomic, but also financial, stability by addressing an important credit market friction known as nonstate contingent nominal contracting (Bullard and DiCecio 2019). That is, many debt contracts specify a fixed stream of nominal repayments, but the future income that will repay this debt is uncertain. Sheedy (2014) shows that with such a friction, NGDP targeting can improve the functioning of financial markets by stabilizing the debt-to-GDP ratio, facilitating efficient risk sharing.

Even as the literature on NGDP targeting and optimal monetary policy continues to grow, (2) policymakers remain hesitant to abandon the status quo. In 2011, the FOMC thought that the time was not right to switch to a new monetary policy framework. In this article, I suggest that the time is better now. I argue that the status quo is so unpopular and precarious that a new target would do more good than harm for central bank credibility. In the current context, the case for NGDPLT is especially strong.

The Federal Reserve and its peers face what Andy Haldane, chief economist at the Bank of England, describes as the "twin deficits" problem: a deficit of understanding and a deficit of trust. He explains, "Because a lack of trust inhibits understanding, and because a lack of understanding contaminates trust, these Twin Deficits are inextricably entwined" (Haldane 2017).

I discuss evidence of the severity of these deficits, based on my own and others' research. Then I argue that the interaction of these deficits with a wave populist sentiment could have major implications for central bank independence and the conduct of monetary policy. Central banks around the world are facing intense political pressures to focus less on inflation and more on the real economy. The flexibility of a dual mandate or a flexible inflation target can invite and exacerbate such pressures by allowing "each side of the political divide to latch onto its preferred policy indicator" (Sumner 2012: 19).

In some cases, central banks have already faced legal changes to their monetary policy frameworks. I will discuss the case of the Reserve Bank of New Zealand (RBNZ), the first central bank to adopt inflation targeting. With a 2018 amendment to the Reserve Bank of New Zealand Act, the RBNZ is also the first to abandon inflation targeting. (3) The RBNZ now has a dual mandate.

The New Zealand experience holds important lessons for inflation targeting central banks and the Federal Reserve. Like RBNZ, these central banks will increasingly face pressure to put more emphasis on employment and other objectives. Whether through new legislation, through the appointments process, or through informal methods, politicians will make it more difficult for central banks to operate independently within their current frameworks. Central banks may be better off changing on their own terms. Adopting NGDPLT could signal concern for the real economy and willingness to break from the status quo, which could fend off populist impulses to change monetary policy in more drastic and potentially harmful ways. In the long term, an NGDPLT could be easier to communicate, more popular, and less prone to political interference than a flexible inflation target or dual mandate.

Unpopular by Design

Modern central banks are unpopular by design. That is, to avoid inflation bias, we delegate monetary policy to a central bank that is independent and conservative, where conservative means that the central bank places a larger weight on inflation stabilization than does society as a whole (Rogoff 1985). This type of delegation allows the central bank to pursue policies that are beneficial in the long run but politically unpopular in the short run (Alesina and Stella 2010).

This unpopularity is readily apparent. The Federal Reserve, in particular, is frequently criticized by progressive think tanks, various interest groups, the president, and parts of the popular press for its emphasis on low inflation, pitted as contrary to the interest of labor and communities. For example, Dylan Matthews of Vox writes that "the Fed has deliberately chosen to keep hundreds of thousands, if not millions, of people from finding work that they could have found with looser policy, in the name of preventing inflation" (Matthews 2019).

"Fed Up" is a coalition of the Center for Popular Democracy, the American Federation of Labor and Congress of Industrial Organizations, and other labor and community organizations that calls on the Federal Reserve "to adopt pro-worker policies for the rest of us." The home page of the Fed Up Coalition (http://whatrecovery.org) adds:

The truth about the economy is obvious to most of us: not enough jobs, not enough hours, and not enough pay-- particularly in communities of color and among young workers. Some members of the Federal Reserve think that the economy has recovered. They want to raise interest rates to slow down job growth and prevent wages from rising faster. That's a terrible idea.... The Fed can keep interest rates low, give the economy a fair chance to recover, and prioritize full employment and rising wages. Why does it matter if central banks are unpopular? Economists and central bankers tend to worry more about central bank credibility than central bank popularity. In the political science literature, however, the concepts of credibility and popularity are closely related. As van Zuydam (2014) notes:

To be credible, leaders need to be competent, trustworthy, and caring for their audience.... The audience's needs, interests and wishes should be perceived to match with what the leader in question has to offer.... After all, credibility is a relational and dynamic concept in which it is the audience who time and again decides whether the leader in question is worthy of being attributed credibility. Economists have typically used a narrower definition of credibility. When Blinder (2000) surveyed central bankers to assess their attitudes about credibility--a "central concern in practical central banking circles"--he intentionally did not define the term, noting that it "is much used these days, and in a variety of different ways." Around 90 percent of central bankers told Blinder that credibility and dedication to price stability were "quite closely related" or "nearly the same." They valued credibility primarily for its presumed role in keeping inflation low and reducing the cost of disinflation.

McCallum (1984) attributes the tight association of credibility with low inflation in the central banking context to Fellner (1976, 1979). (4) Even in 1984, McCallum worried that to conflate credibility with low inflation expectations was "to abuse language as well as to create unnecessary possibilities of confusion." His concern was quite prescient: in 2016, the Financial Times reported that "central banks have resorted to ever more ingenious methods to convince a sceptical public that they still have the ability to create inflation.... The longer they fail to meet their core goals, the more corrosive the effect on their credibility." (5)

Moreover, even with inflation very low, central banks face credibility problems in the form of acute "twin deficits" of understanding and trust, as I will discuss in the next section. In the subsequent section, I will discuss how these deficits might prompt politically motivated challenges to central bank independence and legitimacy.

The Twin Deficits

Haldane (2017) uses the phrase "twin deficits" to refer to the deficits of understanding and deficits of trust facing central banks. The deficit of understanding is well-documented. In a survey I...