NGDP Targeting: A Pathway to Better Growth
What it is and why it matters
Most countries have a central bank that sets monetary policy for the nation. The leaders of these central banks are unelected and (theoretically) apolitical, enabling them to make objective and sometimes unpopular decisions for the greater good. Central banks are mandated to guide actual economic output as close to potential output as possible. But current inflation-rate targeting leaves much to be desired. It is time for a sea-change in how central banks operate.
Central banks, such as the US Federal Reserve, seek to control the money supply to maintain steady prices and manage economic fluctuations. The Federal Reserve works to control inflation by raising or lowering the federal funds rate targeting a specified inflation rate, usually 2 percent. The FED raises rates when inflation exceeds the target and lowers them should the target be missed.
Notably, with inflation rate targeting, if the central bank fails to achieve the targeted 2 percent rate in a given quarter, it simply tries again in the next. Nothing is done to compensate for the gap left from the prior quarter. This leaves potential economic growth on the table, as was evident after the Great Recession, where quarter by quarter, a gap opened between actual and potential output.
Nominal Gross Domestic Product Targeting
Ultimately, it would behoove us to move beyond inflation rate targeting and toward what is known as Nominal Gross Domestic Product targeting, or NGDP targeting. This method is a better alternative because it relieves central bankers from having to determine whether inflation is demand or supply driven…an error that can be costly.
For example, imagine you are a central banker in a fictional nation. The Q2 data comes in; GDP growth stalls, while inflation soars past the 2 percent target. With inflation rate targetting, you must now decide if that inflation is driven by supply constraints or high demand. If inflation is demand-driven, you can raise interest rates to cool the economy/inflation. If it is supply-driven, raising rates will do little except exacerbate the already weak economy.
If you misdiagnose the cause of inflation, which sometimes policymakers do, the economic consequences can be significant. NGDP targeting, on the other hand, eliminates the guesswork for central bankers, creating an automatic stabilization system, by targeting NGDP rather than merely inflation.
Nominal Gross Domestic Product is the sum of all spending in the economy. That spending consists of two components: inflation and economic growth. For example, if GDP grows 2 percent and we have 2 percent inflation, NGDP expanded by 4 percent.
Central bankers might therefore target 4 percent NGDP growth in a given year, with inflation and GDP components allowed to fluctuate independently. In the event of a serious energy supply shock, for example, GDP growth might slow to 1 percent, with inflation accelerating to 3 percent. Even though inflation would be running hot, since the NGDP is still 4 percent, policymakers would not be compelled to raise interest rates.
This is the correct course of action as any monetary tightening would do little for inflation and only slow the economy further. If the GDP and inflation both slow to 1 percent, for a total NGDP of 2 percent, on the other hand, the central bank would do what it could to reach the 4 percent target by increasing the money supply to drive inflation to 3 percent.
Achieving Full Potential
NGDP targeting is better suited for the real world because wages and business contracts are typically set in nominal terms (not inflation-adjusted). This means a drop in total spending (GDP) during a recession can lead to a mismatch between the cost of servicing wages/contracts and the amount of money available to pay them.
When this mismatch occurs, two outcomes arise; either wages need to be cut or employees laid off. Traditionally, employers have been resistant to broad wage cuts and prefer targeted layoffs during downturns. When employees are laid off, they cut spending and borrowing, furthering the downturn.
With NGDP targeting, increased money supply (inflation) during downturns, would make it easier for companies/homeowners to pay wages and service contracts that were set in nominal terms. It is thought that this would prevent the domino effect of layoffs from creating deeper economic pain and spreading this pain into the broader economy.
In addition, it would be wise to level target NDGP. That is, in contrast to current inflation-rate targeting, should central bankers fail to hit the 4 percent NGDP target in a given quarter, they would attempt to exceed the 4 percent figure in the next, working to compensate for the lost economic output of the prior quarter.
The ultimate goal would be to wring out any slack in the employment market and put upward pressure on wages. Such would be particularly helpful in preventing welfare dependence. Studies have shown that when people remain unemployed for a prolonged period of time, they are significantly less likely to rejoin the workforce. Indeed, long-term unemployment is socially and economically destructive.
The failure to attain potential output in the short term lowers potential output in the long term. It is imperative that economic growth and maximum human potential be realized. NDGP targeting would not prevent recessions, it would, however, make some recessions less disruptive. When combined with level targeting, it may also help ensure stronger and healthier growth for long-term prosperity.