Central banks should not just aim to put a lid on inflation, but to raise growth and employment too, according to influential new thinking. Should they? Seán Keyes reports.
What is NGDP?
Gross domestic product (GDP) is probably the best-known measuring stick for an economy. When calculating how much GDP has grown over a certain period, the figure is ‘deflated’ by the rate of inflation. In other words, GDP measures ‘real’ economic growth, rather than growth in spending due to rising prices.
NGDP, on the other hand is nominal GDP – it’s simply the sum of all spending in the economy, regardless of whether this is down to inflation or not.
Why are people talking about it?
Several of the world’s top central bankers are warming to the idea of targeting NGDP growth, rather than inflation. In December, Bank of England governor-in-waiting, Mark Carney (currently head of Canada’s central bank), praised the idea in a speech where he advocated giving central banks more leeway to stimulate the economy. Chancellor George Osborne clearly likes the idea too – after the speech, his spokesman described Carney as “the central banker of his generation”.
In the US, Federal Reserve chief Ben Bernanke is already prioritising employment over inflation, promising to print money until the unemployment rate falls to at least 6.5%. In Japan, the prime minister, Shinzo Abe, has threatened to strip the Bank of Japan of its independence unless it backs him in his goal of getting economic growth up to a nominal 3%.
But why target NGDP growth rather than inflation?
NGDP fans say that central bankers should focus on managing the level of “aggregate demand” – spending, basically – in the economy, as this is where inflation (or a lack of it) stems from. When demand outstrips the economy’s capacity to meet it, you get inflation. When there is too little demand to keep the economy busy, you get a recession.
For example, if demand for a factory’s goods falls, it’ll lay off workers. If there’s more demand than it can handle, it’ll raise prices. Using NGDP would allow central banks to focus on achieving two critical economic goals – not just stable prices, but also full employment.
The central bank would set an explicit NGDP target of, say, 5%. This is reached by adding the economy’s long-term (or ‘trend’) growth rate of about 2.5%, to a long-term desired inflation rate, in this case 2.5% as well. The central bank’s job is to ensure that – via a mix of inflation and growth – NGDP growth stays at around 5%.
So in a boom, when ‘real’ growth is high, more of the 5% NGDP target would be met by growth, and less from inflation. In a recession, the bank could allow inflation to rise to offset weak growth. So if ‘real’ GDP growth is 4%, the bank would have to keep inflation to around 1%, perhaps by raising interest rates.
But if ‘real’ growth was at its current miserable sub-1% levels, the bank would have more scope to allow inflation to rise above 4% to offset this.
Would this work in practice?
Yes, say NGDP advocates. It all boils down to ‘expectations’. In principle, a central bank cuts interest rates (for example) by deciding on the lower rate, then buying financial assets on the open market, using newly created money to hit its target. But in practice, the central bank doesn’t buy or sell anything. It just announces its target interest rate and the market instantly adjusts.
That’s because everyone knows the central bank can print as much currency as it wants, so nobody will bet against it hitting its target rate. So central banking isn’t really about hydraulically pushing money through the system; it’s about making credible promises. From this point of view, a credible target for NGDP growth might be all the economy needs to reach that target.
The Fed is edging towards this with its open-ended commitment to print money until its unemployment and inflation targets are met. So a promise to raise NGDP growth by 5% a year might, paradoxically, see the central bank shrink its already bloated money supply, as long as investors took the target seriously, and began circulating money more rapidly.
So is it a good idea?
The theory isn’t necessarily flawed – at least no more so than the idea that central banks should control interest rates in the first place. And inflation targeting can’t be described as a success – after all, it saw central banks allow a global property and credit bubble to rage on unchecked.
On top of that, the idea that NGDP would be ‘counter-cyclical’ – meaning higher interest rates during booms, and lower ones during busts, also seems more sensible on the surface.
What bothers sceptics – like us – is the timing. It’s rather convenient for heavily indebted governments facing slow or no growth suddenly to favour policies that allow central banks to be more relaxed about inflation. Indeed, shifting the focus from ‘real’ GDP towards NGDP would also distract from our horribly weak growth.
Scott Sumner’s crusade
The fascination with NGDP can largely be attributed to one man: Scott Sumner. Sumner saw the crash of 2008 in terms shared by few others: he believed it to be a catastrophic failure of central bank policy, in allowing NGDP to veer significantly off course. So he started a blog, Themoneyillusion.com.
An economics professor (and Great Depression scholar) at an obscure college in Massachusetts, he didn’t have an audience at first. But he doggedly stuck to his story. Over time it gained traction. Now he’s the “eminence grice” – according to Ambrose Evans-Pritchard at The Daily Telegraph – of a new economic sect called the “market monetarists”.
Regardless of what you think of the theory, Sumner’s rise from obscurity to Foreign Policy magazine’s number 15 ranked ‘global thinker’ in 2012 is a testament to the power of the internet.