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The Case for Nominal-Growth Targeting
An opportunity for Republican candidates on monetary policy


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Texas governor Rick Perry drew criticism recently for suggesting that any attempt by Federal Reserve chairman Ben Bernanke to print money before the 2012 election would be treasonous. Much of the criticism surrounded his use of the word “treason,” but I was puzzled by the conundrum implicit in his statement. The idea that Bernanke would be playing politics by printing money between now and the next presidential election suggests that doing so would improve short-term economic growth and improve President Obama’s reelection prospects. However, if a more expansionary monetary policy would help the economy, why would anyone oppose such a policy, let alone call it treason?

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Perry’s comments reflect a larger problem with respect to views about monetary policy. Some market commentators seem to be just as certain of a significant increase in inflation in the near- to medium-term as others are that there is a need for a third round of “quantitative easing.” This disparity has much to do with how the Fed operates. Indeed, the widespread disagreement and uncertainty about monetary policy presents an opportunity for Republican presidential candidates to argue for significant reform.

Conservatives and other hard-money types have argued that the recent run-up in the prices of gold and other commodities is tied to the significant increase in the size of the Federal Reserve’s balance sheet and, more recently, to increases in the growth of broad monetary aggregates. Others, however, contend that monetary aggregates are poor indicators in and of themselves and point to the recent negative correlation between gold prices and bond yields to suggest that we are seeing a flight to liquidity and a further slowing of economic growth. The problem is that this is not much of a debate, with participants routinely talking past one another. Neither side is going to gain much traction when each group uses different indicators to judge the Fed’s performance. However, this problem could be remedied if the Federal Reserve were required to follow a rule for monetary policy.

Under a monetary rule, the Federal Reserve would be required to target a particular variable, such as inflation or nominal income. With the Federal Reserve targeting a particular variable, it becomes possible to judge the stance of monetary policy as well as the credibility of the Federal Reserve and its commitment to the target. While the indicator variables mentioned above could still be used by market participants and commentators to forecast the Fed’s target, the stance of monetary policy could easily be judged by looking at the deviation of the particular variable from its target. For example, if the Fed announced a target for inflation between 1.5 and 2.5 percent, it could be discerned that monetary policy was too loose when the inflation rate was above that range and too tight when below that range. The Fed would then be responsible in its testimony to Congress to explain why any such deviations occurred.

While the use of a monetary rule is important, it is equally important to choose the correct target. Most central banks in developing countries have adopted inflation targets. This is largely due to the long-run relationship between money and inflation. However, an alternative is targeting nominal income, which has several advantages over targeting inflation.

The work of Milton Friedman and his longtime collaborator Anna Schwartz presents meticulous and convincing evidence not only that inflation is a monetary phenomenon, but also that the business cycle is. According to the theory Friedman built on their empirical results, the main cause of fluctuations in nominal income is changes in actual and desired money balances. When the two differ, individuals seek to resolve the difference by adjusting nominal spending, which obviously changes nominal income. While individuals cannot collectively change the nominal supply of money, they can affect the velocity of circulation. In the short run, deviations between actual and desired money balances will have effects on both prices and real output. In the long run, however, such deviations will only affect prices. A natural policy implication is that the money supply should be adjusted to offset changes in velocity. Since nominal income is the product of the money supply and velocity, targeting nominal income accomplishes that goal.

A nominal-income target has an additional benefit over inflation targeting in that it requires less information and knowledge on the part of policymakers at the Federal Reserve. As noted above, fluctuations caused by monetary factors are divided between prices and real output in the short run, but economists still lack any semblance of a consensus on the precise division. Some variation of the Phillips curve is the closest concept available, but plots of the data look more like a constellation of stars than a stable, downward-sloping curve. By targeting nominal income, however, such a short-run division is made irrelevant.



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