What are the policy’s implications for Kentucky?
By David Beckworth
One of the hottest ideas today in monetary policy is “nominal GDP targeting.” It is not a new idea, but it has gained a lot of attention the past few years because of widespread dissatisfaction with the Federal Reserve. Many view it as a way to improve how the Fed conducts monetary policy. Nominal GDP targeting has supporters across the political spectrum, from conservatives at the National Review to liberals at The New York Times, and has been discussed by Fed officials, including Chairman Ben Bernanke. Some observers believe the Fed’s most recent large-scale asset purchase program, a third round of quantitative easing known as QE3, is an attempt by the Fed to move its policy goal in the direction of a nominal GDP target.
So what is nominal GDP targeting and what is its appeal? With nominal GDP targeting, the Fed’s policy focus is to stabilize the growth of total current dollar spending – or nominal GDP – in the U.S. economy. The idea is to avoid booms and busts in dollar spending growth and, by implication, avoid booms and busts in dollar income growth. (Some also call this approach “nominal income targeting.”)
Figure 1 shows how this would work. The Fed would set a target growth rate, say 5 percent per year, for nominal GDP and adjust monetary policy so that spending hit this target. This would lead to a steady increase in nominal GDP over time. In the top panel of Figure 1, this steady growth is seen as the solid black line. If a spending boom were to suddenly emerge, say due to a housing bubble, then the Fed’s job would be to tighten monetary policy and bring total current dollar spending back to its targeted path. This is represented in the figure by the red line. Conversely, if total current dollar spending were to suddenly collapse, say due to a panic, the Fed would have to ease monetary policy to restore nominal GDP to its target path. This is seen in the bottom panel of Figure 1. The goal is to make the future path of total dollar spending and, as a result, total dollar income as predictable and stable as possible, which assists business in strategic planning for investment.
Seeking price stability didn’t pay off
To understand the appeal of this approach, consider how the Fed operated prior to the fall 2008 economic crisis: During this time it generally aimed to maintain price stability, which for the Fed meant adjusting short-term interest rates so that inflation remained around 2 percent. Thus, during the early to mid-2000s, when rapid productivity gains were pushing down costs and the inflation rate, the Fed responded by easing monetary policy; it was worried that inflation could get too low at this time, even though easing meant further fueling the housing boom. Likewise, in the fall of 2008 when surging commodity prices were creating upward price pressures, the Fed was worried that inflation might get too high. Consequently, it decided at its September 2008 meeting not to ease monetary policy even though the economy was already contracting at a rapid pace.
With a nominal GDP targeting strategy, the Fed would have approached these developments very differently than it did with the policy of maintaining price stability. Since nominal GDP targeting solely aims to stabilize the growth of dollar spending, the Fed would not have worried about the drop in inflation coming from the productivity gains, but it would have worried about the surge in nominal GDP growth coming from the housing boom. It would have tightened monetary policy sooner in the early to mid-2000s, potentially averting some of the housing boom. Similarly, in late 2008 when total current dollar spending was crashing, the Fed would have ignored the higher commodity prices and eased monetary policy to stabilize nominal GDP.
Another way of saying this is that using a nominal GDP target strategy, the Fed would ignore these and other shocks to the supply side of the economy, but it would respond to demand shocks by keeping total current dollar spending stable. One of the big appeals to nominal GDP targeting, then, is that it avoids boom-bust cycles in spending that can arise when the Fed tries to keep inflation stable.
Ironically, even though nominal GDP targeting would make the Fed less concerned about changes to inflation over the business cycle, it would still anchor long-term inflation expectations because of its commitment to keeping dollar income growth on its long-run targeted path. That is, by keeping expected dollar income growth stable over many years, expected price level growth on average also would become stable. This is another appeal of nominal GDP targeting – it would add more long-run certainty about future dollar income growth and price level growth. This would make it easier for businesses and households to make long-term economic plans.
Easier route to a balanced budget
Nominal GDP targeting has another benefit. It makes it easier for the federal government to cut spending and balance the budget. One reason government spending cuts are avoided is the concern that they would be a drag on the overall economy. But if the Fed is there to offset any dollar spending shocks so that nominal GDP stays on its target path, these government spending cuts become easy. That is, for every dollar reduction in government spending, the Fed would ease monetary policy so that there would be a dollar increase in spending by the private sector. This is what happened in Canada in the latter half of the 1990s. Though not explicitly targeting nominal GDP, the Bank of Canada eased monetary policy as the federal government brought its budget into balance. There were no adverse economic effects from this fiscal retrenchment because of the monetary easing.
A related point is that the adoption of nominal GDP targeting would eliminate the argument for countercyclical government fiscal policy. Imagine if the Fed had been targeting nominal GDP going into 2008. It is unlikely in this scenario that the sharp drop in total dollar spending that occurred in late 2008-early 2009 would have happened in the first place. If so, there would have been no need and no justification for the federal government’s almost $800 billion fiscal stimulus package. Similarly, imagine if the Fed in 1929 had been targeting nominal GDP. In this counterfactual, it is unlikely that total dollar spending would have collapsed by 50 percent over 1929-1933 and, as a result, it is unlikely FDR and his New Deal would have emerged politically as they did.
Rapid income growth for Kentucky
So what does all of this mean for Kentucky? If the Fed were to adopt a nominal GDP target, it would probably mean some temporarily rapid dollar income growth for Kentucky. Here is why: U.S. nominal GDP is currently below its pre-crisis trend path, as seen in Figure 2. Advocates of nominal GDP targeting say that the Fed needs to return nominal GDP to its trend path because that is the path business firms and households expected when they entered long-term debt contracts prior to the crisis. Restoring the trend for nominal GDP growth would consequently restore the creditor-debtor relationship and thus allow for a robust economic recovery.
The resulting expected higher nominal income growth also would encourage investors to rebalance their portfolios away from liquid, safe assets toward riskier, higher-yielding ones. This rebalancing would raise assets prices and, in turn, further reinforce the recovery. For these reasons, if the Fed were to adopt a nominal GDP target, it would probably do so with the intention to return nominal GDP somewhere near its previous trend. This would require temporarily faster “catch-up” growth in total dollar spending to return nominal GDP growth to its trend.
Doing so would most likely raise Kentucky dollar spending and dollar incomes, too, since they tend to closely follow U.S. nominal GDP as seen in Figure 2. Currently, Kentucky total personal income growth is about 3.9 percent or roughly $6 billion below its trend path. The Fed adopting a nominal GDP target would probably erase this shortfall. Since there is still slack in the Kentucky economy – the unemployment rate is 8.4 percent compared to a pre-crisis average of about 6 percent – this rise in Kentucky dollar spending and dollar incomes should translate into real economic growth as well.
Now that the presidential election is over, it is more likely that the Fed will think seriously about adopting a nominal GDP target. The Fed’s QE3 program, which has the Fed buying assets until labor market conditions improve in the context of price stability, could easily be reoriented into a nominal GDP target strategy. All the Fed would have to do is explicitly announce a nominal GDP target and continue buying assets until this target was hit and vice versa. This could be an important change in monetary policy in the near future. It is in the interest of all Kentuckians to follow this development.
David Beckworth, Ph.D., assistant economics professor at the Gordon Ford College of Business, Western Kentucky University, is editor of “Boom and Bust Banking: The Causes and Cures of the Great Recession.”
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