When Ben Bernanke talks, economists listen. It was therefore no surprise that the former Federal Reserve (Fed) chair’s keynote address at the American Economic Association’s annual meeting last weekend drew much buzz despite its straightforward message on the mechanics of monetary policy. Bernanke’s speech focused on the tools the Fed has to control monetary conditions as well as how it can credibly target inflation. Bernanke raised important points about the Fed’s ability to fight the next recession. But he should have gone beyond suggesting reforming inflation targeting and considered advocating for nominal gross domestic product (NGDP) targeting as an even stronger framework for producing sound monetary policy. By targeting NGDP, the sum of all nominal spending in the economy (i.e., the
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When Ben Bernanke talks, economists listen. It was therefore no surprise that the former Federal Reserve (Fed) chair’s keynote address at the American Economic Association’s annual meeting last weekend drew much buzz despite its straightforward message on the mechanics of monetary policy.
Bernanke’s speech focused on the tools the Fed has to control monetary conditions as well as how it can credibly target inflation. Bernanke raised important points about the Fed’s ability to fight the next recession. But he should have gone beyond suggesting reforming inflation targeting and considered advocating for nominal gross domestic product (NGDP) targeting as an even stronger framework for producing sound monetary policy. By targeting NGDP, the sum of all nominal spending in the economy (i.e., the nation’s income), the Fed could better smooth out business cycles and actually need less knowledge to implement monetary policy. Before I fully flesh out the arguments for NGDP targeting more deeply, let me return, briefly, to Bernanke’s address.
The lecture highlighted the tools the Fed has to control monetary conditions: the federal funds rate (its most conventional instrument), quantitative easing (or “QE,” the purchase of longer-term securities), and forward guidance (communication about future policy). Bernanke himself largely pioneered the latter two tools on a somewhat ad hoc basis when he helmed the Fed during and after the Great Recession. His speech took a fairly positive view of the Federal Reserve’s current toolkit, arguing that it will likely be sufficient to combat the next recession.
But he offered one significant caveat: this optimistic projection assumes that the nominal neutral interest rate, or the interest rate at which monetary policy is neither inflationary nor deflationary, will be around two percent or higher. If that rate is actually lower than two percent, then other policy tools, including the controversial ability to set negative interest rates as well as fiscal stimulus, may be needed.
Bernanke also mentioned the possibility of raising the Fed’s two percent inflation target to drive up nominal interest rates further. This action would give the Fed has more room to cut rates to stimulate the economy in the event of a downturn. However, he also cautioned that higher inflation brings serious costs, including “uncertainty and volatility” associated with changing inflation expectations, suggesting that the existing monetary tools should be exhausted before turning to a higher inflation target.
In wrapping up his comments, Bernanke argued that central banks should formally add QE and forward guidance to their toolkits so markets are not left guessing what monetary policy might look like in the future. He also emphasized the importance of keeping inflation and inflation expectations close to target. He pointed out that in Japan and Europe, central banks have consistently failed to hit their inflation targets. This causes inflation expectations and nominal interest rates to fall, leaving central banks with less room to cut rates when necessary. Furthermore, he argued, central banks should treat inflation “symmetrically” by allowing inflation to overshoot their targets just as much as they undershoot in order to hit their exact targets on average over time.
Central banks should always be clear with what tools they will use. Since QE and forward guidance are likely to be used during the next recession, then Bernanke is right that central banks should explicitly adopt these tools. Furthermore, central banks need to be credible in order to fulfill their government mandates. Therefore, if central banks are going to target inflation, then it’s important for inflation to be close to central banks’ stated targets.
A Better Way Forward
But there is a better way to achieve Bernanke’s goal of macroeconomic stability than symmetrical inflation targeting: NGDP targeting. By targeting NGDP, the Fed would produce countercyclical inflation because NGDP growth, by definition, equals inflation plus the growth in real output. Therefore, when real output or economic growth slows, as it does during a recession, inflation automatically rises to keep nominal GDP growth stable. This helps keep nominal wages stable, reducing the real debt burden facing individuals and firms during the downturn.
NGDP targeting also makes more sense during those times when technological improvements allow society to become more productive and make the same goods and services at lower cost. In this case, real output rises, and inflation automatically falls. Under this second, happier scenario, consumers can enjoy lower prices, and the economy continues to grow.
Thus, NGDP targeting delivers the “best of both worlds”: higher inflation when needed to ameliorate recessions, but lower inflation when the economy is expanding. It also avoids Bernanke’s concern of a permanent higher level of inflation on average.
NGDP targeting is also superior to inflation targeting because the central bank does not need to know as much about the economic situation to effectively use it. For instance, when using inflation targeting, changes in the price level can result from changes in supply or demand, but it can be difficult to know in real time what is triggering those changes. Under NGDP targeting, that’s OK: the central bank does not need to know whether supply-side or demand-side changes are affecting the price level, so long as it keeps the total volume of spending stable.
Under inflation targeting, however, the central bank does need to know, and if it errs, it can exacerbate rather than mitigate booms and busts. For example, in 2008, the Fed was concerned about rising commodity prices from possible negative supply-side shocks, including political stability and poor harvests. Because these rising prices caused inflation to appear higher than it was, the Fed counterproductively tightened monetary policy just as the economy was entering recession. The European Central Bank made similar mistakes in 2008 and 2011 in response to rising commodity prices, which greatly worsened economic conditions.
If these central banks were targeting NGDP instead, they would not have tightened monetary policy simply because commodity prices were higher. Instead, they would respond only to changes in the overall sum of spending in the economy.
How can the Fed implement NGDP targeting? A central bank can use any and all of the tools Bernanke describes in his address when targeting NGDP. Moreover, contra Bernanke’s recent comments, the Fed does not actually need assistance from fiscal policy in providing liquidity during a recession. A central bank with a fiat currency is never really “out of ammunition” to raise inflation or NGDP because it can continually buy assets and increase the money supply, even when the nominal neutral interest rate is zero. Therefore, fiscal stimulus in principle is not really necessary to help a central bank combat a demand-driven recession. In fact, this was Bernanke’s own view in 1999 when writing about the deflationary experience in Japan:
If the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence.
Perhaps central banks face political or legal barriers to achieving their respective inflation targets, such as limitations in the form of assets they can buy. But this is a policy problem, not an economic barrier to central banks using monetary policy to achieve a certain amount of inflation or—even better—nominal GDP growth.
Bernanke is right to assess the efficacy of different monetary tools and to highlight the importance of monetary regimes, especially as the world is increasingly confronted with the unusual phenomenon of very low interest rates. He is also correct to warn against a higher inflation target if other options are on the table. He should go a few steps further. NGDP targeting can not only be achieved through all of the important tools he believes central banks will need in the brave new monetary world, it would also be much more effective than inflation targeting in the Fed’s mission of achieving low inflation and low unemployment.