Targeting Nominal Growth: A Policy for Stagflation?


Should the Federal Reserve abandon its traditional tactic of targeting interest rates in favor of targeting a specific level of nominal gross domestic product?

This idea—known as NGDP targeting—has recently emerged as one of the hottest topics in economics. Bentley University economist Scott Sumner deserves a lot of the credit for popularizing the concept that has recently been endorsed by Goldman Sachs economists Jan Hatzius and Sven Jari Stehn, Paul Krugman and many others.

The basics are rather straightforward. Instead of targeting levels for the Fed Funds rate—which is how the Fedhas conducted its monetary policy for some time—the Fed would target the non-inflation adjusted—or “nominal”— growth of the economy.

This entails a couple of things. For one, the Fed would be saying that it would tolerate much higher levels of inflation than people currently expect. Right now it is assumed that the Fed has an implicit inflation target of around two percent. NGDP targeting would mean that the Fed would pretty much ignore how high inflation rises so long as growth rises less than its stated goal.

The advocates of NGDP targeting view it primarily as a communications strategy. It’s a way of telling the markets that the Fed will stay very loose for an extended period of time, even if this looseness becomes inflationary.

Of course, in conjunction with communicating the goal, the Fed would have to communicate a credible strategy to achieve the goal. How exactly will it pursue the goal of higher nominal growth? Most likely it would have to commit to a very aggressive, open-ended asset purchasing program. No more QEwith limited dollar amounts. This would be a throw-open-the-vaults policy.

It’s not clear, however, that this will lead to growth. In fact, some of the proponents seem to think that the announcement of an NGDP target would just magically lead to growth.

“It [announcing the goal plus the purchase plan] would cause such an upward explosion in asset prices that no purchases would be necessary,” Sumner has written.

That almost sounds like magical thinking. Or magical monetary policy. And one advocate of NGDP Targeting describes it as “Chuck Norris” monetary policy.

“Chuck Norris simply looks at the target variable, and it moves to wherever he wants it to go. It looks like magic. But it works because nobody wants Chuck Norris to carry out his implicit threat. So he doesn't need to,” Nick Rowe has written.

So how is that supposed to work? The idea is that the Fed, by changing expectations about its own policies, would push down long-term interest rates, which encourages businesses and households to borrow and invest. At the same time, people would start to expect higher inflation and decide to consume more before inflation devalued their dollar savings.

This policy might be effective in certain economic situations. But I’m not sure it works when household balance sheets are burdened with too much debt. That is the actual economic situation we find ourselves in today.

A debt-burdened business or household would not necessarily increase its spending in the expectation of future inflation. For one thing, many people may not be able to do so even if they wanted to because their debt service is too high to allow them to divert income to consumption. For another, much of household debt is not inflation sensitive, which means that the dollars they must use to pay down their debt are not devalued by inflation. The debt-constrained aren’t worried about their dollars being devalued.

In fact, the policy could backfire. Households worried about rising prices may save more. If you knew the price of your weekly grocery bill were growing up, you might start saving more to compensate for the higher prices. If too many people divert money into savings and away from current spending, this could create deflation .

Economists might say that this would be irrational because wages would go up with prices. But is that a credible claim?

Kelly Evans from the Wall Street Journal explains:

Consider how recent gains in the consumer-price index, particularly in food and energy, have outstripped any increase in wages. This has hurt real income growth, undermined consumer confidence, and weakened, not strengthened, the economy.

For the Fed to generate inflation, it needs households to believe the central bank is fueling not just higher prices but wage gains, too, so that they start spending more. Otherwise, households will simply tighten the purse strings instead.

Businesses aware that the government has a nominal growth target may not expand because they realize that rising prices and cheaper credit do not reflect actual increases in wealth—just nominal increases. You don’t build a new factory or hire new workers just to keep up with rising prices. In fact, you may pull back from hiring for fear that prevailing wages may rise faster than your own profits.

Many businesses with large cash balances might feel threatened by the implicit inflation threat. But they won’t necessarily respond by expanding. A business that does not see bright prospects for expansion—that is, the opportunity for real profits—will not necessarily prefer risky expansion over inflation-losses of value to its cash balance. It will depend on how it views its prospects.

Banks will not necessarily increase lending just because the Fed is flooding the banking system with dollars. Lending will remain constrained by the demand for loans by credit worthy borrowers. The size of the reserves of the banks is largely irrelevant to their lending.

In short, its not at all clear that nominal targeting will work as promised—much less generate real economic growth. And it could set off a deflationary spiral that would lead up into low growth and rising prices. In other words, stagflation.

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