Alarmed by the enormous discretion the Federal Reserve has to set monetary policy, and often disagreeing with the way it has used that discretion, some congressmen want to pass new legislation to narrow its mandate. Right now it is empowered to do what it can to achieve both price stability and full employment — but how it makes trade-offs between these goals, and how it seeks them, are left unspecified. Setting a rule that both limits the damage that the Fed can do and establishes democratically determined guidelines for one of the government’s most important policies is undeniably attractive. But whether legislation would make the situation worse or better depends entirely on what rule it imposes.
The best rule would force the Fed to try to stabilize total current-dollar spending or nominal GDP around some targeted growth path. For example, it could target a 5 percent yearly growth rate in nominal GDP. That target would, on historical patterns, result on average in 3 percent real economic growth and 2 percent inflation each year. This approach, called nominal-GDP targeting, has become increasingly popular lately because of the economic crisis. Even the Federal Reserve discussed it during its September 2010 meeting.
The appeal of nominal-GDP targeting comes from its simplicity, its appropriate focus, and its ability to enhance long-term certainty.
The simplicity of this approach can be illustrated by considering how the Federal Reserve would have responded to the sharp downturn of 2008–09 had it been targeting nominal GDP. During this time, the financial system was in distress and, as a result, there was a rush for liquidity. The rise in demand for highly liquid assets meant less spending and a drop in economic activity. Had the Federal Reserve been targeting nominal GDP at this time, it would have provided enough liquidity to fully offset the spike in liquidity demand. Such a response would have stabilized actual and expected nominal-GDP growth in 2008–09 and prevented the collapse of the economy. It is that simple.
Some may object that nominal-GDP targeting could not have prevented the 2008–09 crisis, because it was the beginning of a deleveraging cycle. According to this view, such “balance-sheet recessions” simply are not amenable to monetary-policy fixes. This understanding, however, fails to recognize that for every debtor who is cutting back on spending there is a creditor receiving money payments. Creditors should have increased their spending to offset the decline in debtor spending. They did not, because their expectations of economic activity were allowed to worsen, something that would not happen with a nominal-GDP target that anchored spending expectations.
A nominal-GDP target focuses monetary policy appropriately because it responds to spending shocks only. To see this point and its importance, imagine that a new technology makes computers much faster. This productivity-enhancing supply shock would create disinflation. With a nominal-GDP growth-rate target of 5 percent, this shock might temporarily result in 5 percent real economic growth and 0 percent inflation. In contrast, a rigid inflation target of, say, 2 percent in conjunction with the 5 percent real economic growth would require 7 percent nominal-GDP growth, or a potentially destabilizing surge in spending. Better to ignore the supply shock and allow the temporary disinflation than to have a boom in spending.
Now consider a super-virus that temporarily shuts down most computer systems. This negative supply shock would decrease productivity and increase prices. This might, for example, result in 0 percent real economic growth and 5 percent inflation. Here, a 2 percent inflation target would require a tightening of monetary policy that would further constrict an already weakened economy. A Federal Reserve that was targeting nominal GDP would not face this dilemma. It would simply keep total current-dollar spending stable at 5 percent growth and allow the supply shock to work itself out.
Nominal-GDP targeting also enhances long-term certainty by communicating clearly to the public the long-run trend for spending. Thus, if spending actually falls by 2 percent one year, then the following year the Fed would have it grow by 12 percent to get it back on its 5 percent growth trend. This feature would create spending expectations that would automatically tend to keep nominal GDP on trend. Spending shocks like the ones in 2008–09 would therefore be less likely to occur.
The Fed could reasonably be held accountable for this policy, which asks it to pick one target. But that target is well chosen, since hewing to it provides a stabilizing influence on both inflation and real economic growth (which sum up to nominal-GDP growth). If Congress really wants to narrow the Federal Reserve’s mandate, it should consider nominal-GDP targeting.
— David Beckworth was formerly an economist with the U.S. Department of the Treasury and is currently an assistant professor of economics at Texas State University.