Why the United Kingdom Should Adopt a Nominal GDP Target

The review [pdf] of the United Kingdom’s monetary policy framework published alongside the budget on March 20 reveals that the UK Treasury has ruled out replacing inflation targeting with nominal GDP targeting. That is a shame. Nominal GDP targeting would provide more space for the Bank of England to support the recovery in the near term while maintaining a credible nominal anchor and introducing a more robust policy framework for the long term. While it is no silver bullet, nominal GDP targeting would be preferable to the changes set out in the review.

Would a shift to nominal GDP targeting represent a big change in the United Kingdom’s monetary policy framework? In the United Kingdom the government (Chancellor of the Exchequer) sets the remit for the Monetary Policy Committee (MPC) of the Bank of England. The Bank has operational independence in choosing the tools and policies to meet its objectives. The current MPC remit states that “the objectives of the Bank of England shall be: (a) to maintain price stability, and (b) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment.”

Recent policy decisions show that the MPC already cares about stabilizing output as well as inflation. The MPC has shown itself willing to tolerate higher inflation in the near term to avoid exacerbating the recession with tighter policy. This is nevertheless consistent with its remit because the best collective judgment of the committee has been that inflation would fall back to target in the medium term (within two to three years). Recent communications go even further in this direction. The MPC is now ready to tolerate higher inflation even in the medium term and to bring inflation to target over a longer horizon than it sought in the past. It may therefore seem that a move to nominal GDP (NGDP) targeting would amount to nothing more than the recognition of output in the Bank’s objective function with little practical change to the way policy is made.

To appreciate the difference between inflation targeting and NGDP targeting, it is important to distinguish between targeting the growth rate of NGDP and targeting a path for NGDP. Under the former, as under inflation targeting, policy is undertaken in a purely forward-looking manner. The central bank seeks to meet the growth target within the time horizon over which monetary policy affects the target variable, ignoring past misses. Targeting the path for NGDP, on the other hand, is more akin to targeting a price level. Within this framework, policy becomes history dependent. The central bank still bases its policy on forecasts for the target variable, but it must compensate for past deviations from the target path/level.

The targeting of a path for NGDP has generated interest in the economics profession in recent years. The immediate concern motivating this interest is the weakness in advanced economies and the slow pace of recovery from the Great Recession, despite near-zero policy rates and large doses of quantitative easing (QE). In this context, the argument of the economist Michael Woodford for NGDP targeting has been particularly influential. The history-dependence of this framework is the key to its success at the lower bound. Compared to inflation targeting, targeting a path for NGDP implies a longer period during which interest rates remain at the lower bound. This is because the collapse in NGDP below the target path during the Great Recession would need to be compensated with higher NGDP growth in the future.

Expectations of lower future policy rates would help to push down on the full range of long-term interest rates relevant for economic decisions, stimulating spending and investment. Because a switch to NGDP targeting implies looser policy while the economy recovers (though not in the long term as explained below), it may be accompanied by temporarily higher inflation expectations, which would further push down on real interest rates and thus help to stimulate activity. Woodford notes that the short-term boost to activity would be particularly large in the current situation when the lower bound on policy rates is binding because of the absence of monetary policy tightening that higher spending would prompt in normal times.

Does NGDP represent a new and powerful tool in central banks’ arsenals?

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