Finding the Target

by Ramesh Ponnuru

Most people who follow monetary policy at all are familiar with the idea that central banks should follow an inflation targeting rule: trying to keep inflation at roughly 2 percent per year, for example. Recent years have seen a revival of interest in the idea that central banks should follow a different rule, targeting the growth of nominal income rather than of the price level.

At Investor’s Business Daily, Alan Reynolds criticizes that idea; David Beckworth responds.

Two additional points:

1) Reynolds writes, “If we had experimented with a 5% NGDP target in the past, it would mean that from 1983 to 2000, the Fed should have tightened policy more aggressively than it did during every single year but 1991.

“Yet those were years of strong economic growth and declining inflation.”

The Fed’s loose-money policies of the ’60s and ’70s made NGDP rise (and fluctuate) a lot. It would not have been sensible to move immediately to a rigid 5 percent-per-year rule in that context. But that’s not a good reason to reject the idea of moving gradually to an NGDP rule. A sensible advocate of, say, a 0 percent inflation rule would also not have advised its immediate implementation in 1980. Macroeconomic stabilization is, after all, largely the goal of such policies.

2) He finishes: “If and when inflation and nominal GDP targets send conflicting messages, however, inflation is the one that matters. It can never be a matter of indifference whether the growth of NGDP consists of rapid real growth with little inflation (as in 1998), or rapid inflation with negative real growth (as in 1982).”

NGDP targeting does not presuppose — and no rational person would presuppose — indifference between inflation and real economic growth. It is always preferable for any given level of NGDP growth to be made up as much of real growth, and as little of inflation, as possible. But there’s a limit to how much a central bank can influence real growth rates. And if a central bank responds to inflation rather than NGDP when the two send conflicting signals, it will have to make business cycles more intense.

It will have to respond to a deflationary productivity boom by loosening money, and to a contractionary supply shock by tightening it. NGDP targeting is that it would avoid this perversity, which is an important reason for thinking it superior to inflation targeting.

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