Nominal GDP Targeting: Still a Skeptic

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December 28, 2012

Nominal GDP Targeting: Still a Skeptic

In a few days the clock will run out on another year of disappointing economic growth in the United States and, generally speaking, in the world. It is inevitable and appropriate, then, that the year-end ritual of looking forward by looking backward will include an assessment of whether more or better policy can contribute to a pick-up in growth that failed to materialize in 2012.

To this discussion, Harvard professor Jeff Frankel brings some fresh thinking to the not-quite-fresh notion that the Fed should adopt a nominal gross domestic product (GDP) targeting approach as a replacement for existing central bank practice'described by Frankel and others as policy driven by an inflation-targeting framework. What I particularly like about Frankel's proposal is the fact that he offers up a practical roadmap for using the Fed's current communications tools to transition to an explicit nominal GDP targeting framework. If I were inclined to think such a move would be a good idea, I would view Frankel's proposal with some enthusiasm. Alas, I am not yet so inclined.

As to the case for skepticism on theoretical grounds, I commend to you this excellent post by Mark Thoma at Economist's View. But Professor Frankel suggests a case for nominal GDP targeting on practical grounds by appealing to this counterfactual:

A nominal GDP target for the US Federal Reserve might have avoided the mistake of excessively easy monetary policy during 2004-06, a period when nominal GDP growth exceeded 6 per cent.

Maybe. Average annual real GDP growth over those three years was just over 3 percent, compared to the Congressional Budget Office (CBO) estimates of potential GDP growth of just under 2.5 percent. That's not a big difference, but more importantly the average gap between the level of real GDP and the CBO estimate of potential was just 0.3 percent of average output'essentially zero. The importance of this so-called "output gap" becomes evident if you read the Michael Woodford interview referenced in the aforementioned piece at Economist's View. In that interview, Woodford says, "The idea was to talk about a price level, as opposed to the inflation rate, but a corrected price level target where you add to it some multiple of the real output gap." So for him, something like this measure would be a key element of his proposed monetary policy rule.

What if, rather than some measure of nominal GDP, the 2004'06 Fed had instead been solely focused on the inflation rate? You can't answer that question without operationalizing what it means to be "focused on the inflation rate," but for the sake of argument let's simply consider actual annualized PCE inflation over a two-year horizon. (In his press statement explaining the Federal Open Market Committee's (FOMC) latest decision, Fed Chairman Ben Bernanke suggested using a one- to two-year horizon for inflation forecasting horizon to smooth through purely transitory influences on inflation that the central bank would inclined to "look through.") Here's the record, with the period from 2004 through 2006 highlighted:

If you really do think that there was a policy mistake over the 2004'06 period'and in particular if you believe the FOMC during that should have adopted a more restrictive policy stance'I'm hard-pressed to see what advantage is offered by focusing on nominal GDP rather than inflation alone. In fact, you could argue that that the GDP part of the nominal GDP target would have added just about nothing to the discussion.

I add the observation in the chart above to my earlier comments on an earlier Frankel call for nominal GDP targets. To summarize my concerns, the Achilles' heel of nominal GDP targeting is that it provides a poor nominal anchor in an environment in which there is great uncertainty about the path of potential real GDP. As I noted in my earlier post, there is historical justification for that concern.

Basically, anyone puzzling through how demographics are affecting labor force participation rates, how technology is changing the dynamics of job creation, or how policy might be altering labor supply should feel some humility about where potential GDP is headed. For me, a lack of confidence in the path of real GDP takes a lot of luster out of the idea of a nominal GDP target.

By Dave Altig, executive vice president and research director at the Atlanta Fed

 

December 28, 2012 in Federal Reserve and Monetary Policy, GDP, Monetary Policy | Permalink

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Try, Try Again

« Plain English | Main

December 21, 2012

Try, Try Again

As a regular, satisfied customer of The Wall Street Journal's "Heard on the Street" feature, I was a bit distressed to read this, from an item titled "Bonds Beware Central Bank Regime Change":

In the U.S., the Federal Reserve has announced that future monetary policy tightening will depend on a hard target for falling unemployment and a softer target for rising inflation expectations. That looks like a tilt toward growth as the priority over inflation.

When The Financial Times and The Wall Street Journal in quick sequence publish articles that seem to misinterpret Fed communications, I have to surmise that the message isn't getting through and bears repeating and further explaning.

Earlier this week, in response to the alluded-to FT article, I addressed the charge of a "tilt toward growth as the priority over inflation," noting that Fed Chairman Ben Bernanke clearly indicated in last week's press conference that there has been no "change in our relative balance, weights towards inflation and unemployment...."

It is true that the Committee's threshold for considering policy action was expressed in terms of a realized value for unemployment and a forecast value for inflation. But that choice, as the Chairman explained in that press conference, was motivated by the nature of the two different statistics:

... the Committee chose to express the inflation threshold in terms of projected inflation between one and two years ahead, rather than in terms of current inflation. The Committee took this approach to make clear that it intends to look through purely transitory fluctuations in inflation, such as those induced by short-term variations in the prices of internationally traded commodities, and to focus instead on the underlying inflation trend.

More importantly, the plan is not to ignore the incoming data and rely solely on internal Committee forecasts:

In making its collective judgment about the underlying inflation trend, the Committee will consider a variety of indicators, including measures such as median, trimmed mean, and core inflation; the views of outside forecasters; and the predictions of econometric and statistical models of inflation. Also, the Committee will pay close attention to measures of inflation expectations to ensure that those expectations remain well anchored.

Even more important, in my view, this broad approach to assessing price-stability conditions is also the approach the Chairman described in thinking about the allegedly hard target for the unemployment rate:

... the Committee recognizes that no single indicator provides a complete assessment of the state of the labor market and therefore will consider changes in the unemployment rate within the broader context of labor market conditions.

It is fair to point out the difficulties that can arise in implementing this policy strategy in the real time, real messy world. And if you doubt that the Committee is as good as its word, there is probably not much I can say that will convince you otherwise. But we ought to at least take care in being clear what the Committee's word actually is.

By Dave Altig, executive vice president and research director at the Atlanta Fed

 

December 21, 2012 in Federal Reserve and Monetary Policy, Monetary Policy | Permalink

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Plain English

« Anticipating Growth despite a Slowdown? Results from the Recent Small Business Survey | Main

December 17, 2012

Plain English

Gavyn Davies writes in The Financial Times (hat tip, Mark Thoma) that he sees a major shift in attitude at the Fed:

In the US, there has been a clear shift in the Fed's policy reaction function, or "Taylor Rule", increasing the weight placed on unemployment and reducing the weight on inflation. The nature and importance of the Fed's policy shift has not yet been fully understood, because it was not really spelled out by Chairman Bernanke in his press conference this week.

I'd score that comment about half accurate. Here's what the Chairman actually said in that press conference:

QUESTION:
Mr. Chairman, what prompted the Committee to make the decision at this particular time to specify targets? And by taking an unemployment rate that is quite low compared to currently, does that shift the balance of priorities in terms of your dual mandate'more in the direction of reducing unemployment rather than inflationary pressures?

BERNANKE:
'It is not a change in our relative balance, weights towards inflation and unemployment, by no means. First of all, with respect to inflation, we remain completely committed to our 2 percent longer- run objective. Moreover, we expect our forecast, as you can see from the summary of economic projections, our forecasts are that inflation will actually remain'despite this threshold of 2.5 [percent]'that inflation will actually remain at or below 2 percent going forward'

I think both sides of the mandate are well-served here. There's no real change in policy. What it is instead is an attempt to clarify the relationship between policy and economic conditions.

That's about as clear a statement about the constancy of the Federal Open Market Committee's (FOMC) objectives as I can imagine. The reason I am giving Davies half credit is his reference to the Taylor rule, and his article's theme that what has changed is the FOMC's "reaction function"'a fancy name for how the Fed will respond to changes in economic conditions in pursuit of its objectives.

I think the intent of recent changes in language is pretty clear, evidenced by comparing this statement following the August FOMC meeting'

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

' with this one, introduced after the September FOMC meeting:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

I added the emphasis above, as in my view it is the key change from previous statements. At least from the point of view of the Atlanta Fed's research staff, there wasn't much of a shift in the economic forecast between August and September (or September and December, for that matter). The change in date from late 2014 to mid-2015 is (I argue) best understood, not in terms of changing economic conditions, but in terms of this explanation, from Mike Woodford's paper presented at the Federal Reserve Bank of Kansas City's 2012 Economic Symposium:

We argue for the desirability of a commitment to conduct policy in a different way than a discretionary central banker would wish to, ex post, and show that (in our New Keynesian model) the optimal commitment involves keeping the policy rate at zero for some time after the point at which a forward-looking inflation-targeting bank (or a bank following a forward-looking "Taylor Rule") would begin to raise interest rates.

This, of course, is exactly the change in reaction function to which Davies refers. But two points need to be emphasized. First, the deviation from the Taylor rule that Woodford describes is an exceptional measure designed to deal with circumstances in which policy rates have fallen to zero and can fall no more. Deploying such measures in the current extraordinary circumstances need not reflect some fundamental change in the approach to policy when things return to conditions that more closely approximate normal.

Second, and more importantly, the Chairman's comments make it abundantly clear that whatever changes may have occurred in how monetary policy is implemented, there is in no way a change in the weight the Committee puts on its price stability mandate. On that there should be no confusion.

By Dave Altig, executive vice president and research director at the Atlanta Fed

 

December 17, 2012 in Federal Reserve and Monetary Policy, Monetary Policy | Permalink

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Anticipating Growth despite a Slowdown? Results from the Recent Small Business Survey

« Gazelles, and Why They Matter | Main

December 12, 2012

Anticipating Growth despite a Slowdown? Results from the Recent Small Business Survey

The latest reading on the Wells Fargo/Gallup's Small Business Index indicated business conditions for small firms dropped to the lowest levels since July 2010 (see the chart), and index also said:

Key drivers of this decline include business owner concerns about their future financial situation, cash flow, capital spending, and hiring over the next 12 months.

The latest iteration of the Atlanta Fed's small business survey, which was conducted in October, also noted a decline in 12-month-ahead expectations for sales, hiring, and capital spending (see the chart).

Dissecting this by firm age, the overall decline in expectations stemmed from the firms in our sample that were more than five years old (see the charts).

Over the life of the survey, young firms have tended to be more optimistic about changing business conditions. Are these young firms simply naïve about changing economic conditions, or are they anticipating growth despite expectations for a pullback in the broader economy? We asked the following question this time around in an attempt to capture the business owners' aspirations and job-creating "gazelle" potential:

Five years from now, do you anticipate your business will be:

a) Smaller
b) About the same
c) Somewhat larger
d) Significantly larger

It turns out the group is an optimistic bunch: 30 percent of employer firms said they thought their business would be significantly larger in five years, and firms under six years of age were twice as likely to say so (see the chart). Considering that young firms also tend to have smaller operations than mature firms (the median young firm had from $100,000 to $500,000 in annual revenues and the median mature firm had from $1 million to $7 million), this difference is not shocking.

What was a little surprising was how few of the young firms said they thought they would be smaller in five years. Research suggests that that only about half of businesses make it past five years, and yet only three young firms identified themselves as shrinking. There is always the chance that these young businesses will become fast-growing, job-creating gazelles. After all, a recent study of high-growth firms by the Kauffman Foundation found the average age of the fastest-growing firms in 2010 was only seven years old.

Will they achieve their goals? Only time will tell.

The Atlanta Fed's third quarter small business survey, which asks firms questions about business and financing conditions, is available on our website.

By Ellyn Terry, a senior economic analyst in the Atlanta Fed's research department

 

December 12, 2012 in Small Business | Permalink

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Anticipating Growth despite a Slowdown? Results from the New Small Business Survey

« Gazelles, and Why They Matter | Main

December 12, 2012

Anticipating Growth despite a Slowdown? Results from the New Small Business Survey

The latest reading on the Wells Fargo/Gallup's Small Business Index indicated business conditions for small firms dropped to the lowest levels since July 2010 (see the chart), and index also said:

Key drivers of this decline include business owner concerns about their future financial situation, cash flow, capital spending, and hiring over the next 12 months.

The latest iteration of the Atlanta Fed's small business survey, which was conducted in October, also noted a decline in 12-month-ahead expectations for sales, hiring, and capital spending (see the chart).

Dissecting this by firm age, the overall decline in expectations stemmed from the firms in our sample that were more than five years old (see the charts).

Over the life of the survey, young firms have tended to be more optimistic about changing business conditions. Are these young firms simply naïve about changing economic conditions, or are they anticipating growth despite expectations for a pullback in the broader economy? We asked the following question this time around in an attempt to capture the business owners' aspirations and job-creating "gazelle" potential:

Five years from now, do you anticipate your business will be:

a) Smaller
b) About the same
c) Somewhat larger
d) Significantly larger

It turns out the group is an optimistic bunch: 30 percent of employer firms said they thought their business would be significantly larger in five years, and firms under six years of age were twice as likely to say so (see the chart). Considering that young firms also tend to have smaller operations than mature firms (the median young firm had from $100,000 to $500,000 in annual revenues and the median mature firm had from $1 million to $7 million), this difference is not shocking.

What was a little surprising was how few of the young firms said they thought they would be smaller in five years. Research suggests that that only about half of businesses make it past five years, and yet only three young firms identified themselves as shrinking. There is always the chance that these young businesses will become fast-growing, job-creating gazelles. After all, a recent study of high-growth firms by the Kauffman Foundation found the average age of the fastest-growing firms in 2010 was only seven years old.

Will they achieve their goals? Only time will tell.

The Atlanta Fed's third quarter small business survey, which asks firms questions about business and financing conditions, is available on our website.

By Ellyn Terry, a senior economic analyst in the Atlanta Fed's research department

 

December 12, 2012 in Small Business | Permalink

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