Last month, Federal Reserve Chair Jerome Powell spoke at the Cato Institute’s annual monetary policy conference. During his conversation with Cato’s president, Peter Goettler, he was asked about targeting nominal income or nominal GDP as an alternative framework for monetary policy. Nominal GDP (NGDP) targeting is a regime where a central bank attempts to stabilize NGDP, the total sum of spending in the economy, rather than other targets such as inflation and employment. Although many economists have argued for some form of NGDP target over the years, no central bank has explicitly adopted the idea.
Powell answered that while he thinks nominal GDP targeting is an interesting idea that works well in models, he and his colleagues at the Fed do not think it is the best way to achieve the Fed’s dual mandate of full employment and price stability.
Why not? In Powell’s view, “it would be very difficult . . . to explain to the public the relationship between [an NGDP target and] those goals. It’s . . . a level of complexity that even some economists and policymakers struggle with, let alone the general public.” Powell also observed that the trend growth of real GDP—that is, the sustainable rate at which the economy can grow—is revised over time. Since NGDP growth is the sum of real GDP growth and inflation, changes to the trend in real GDP growth could create problems in communicating and implementing such a framework.
While communication and data revision are commonly cited objections to NGDP targeting, they are not insurmountable. First, it’s not clear that the public necessarily would even need to know how NGDP targeting works. A recent poll showed that only a very small minority (7%) of Americans think of themselves as knowing “a lot” about the Fed’s responsibilities. A similarly tiny sliver understood that full employment is part of the Fed’s mandate. A larger number, but still a minority (34%), understood that price stability is the other part of the Fed’s mandate.
Admittedly, this is only one poll, but there is widespread evidence that the public knows very little about the workings of American government and public policy generally. If Americans are unlikely to know who controls Congress or how the federal government spends its money, they are even less likely to have a meaningful grasp of how the Fed works to specifically achieve its mandate. Further, NGDP targeting is actually simpler to understand than the Fed’s current approach to monetary policy in multiple respects.
The Fed’s Current Approach
Consider the Fed’s current approach to achieving its mandate: “flexible average inflation targeting,” or FAIT. Before FAIT’s adoption in 2020, the Fed tried to achieve an annual 2% inflation rate as measured by changes in a basket of goods called the Personal Consumption Expenditures (PCE) Price Index. If it missed its target, it would simply try to hit the 2% target again the following period, without trying to make up for that previous miss. This approach is sometimes called simple inflation targeting because the central bank does not take previous misses of the target into account.
For years, the Fed regularly undershot this 2% goal. While many people prefer low inflation, the Fed was concerned that its seeming inability to achieve its stated target undermined its credibility. Also, lower inflation leads to lower nominal (i.e., inflation-unadjusted) interest rates. Because the Fed primarily relies on cutting its interest rate target to stimulate the economy in the event of a recession, it was concerned that it did not have enough wiggle room in the case of a downturn because interest rates were already close to zero.
In 2020, the Fed switched to a new framework where it would “achieve inflation that averages 2 percent over time,” again as measured by changes in the PCE. To this end, the Fed intended to overshoot 2% to make up for previous undershoots. However, this new average inflation target was flexible for at least three reasons. First, the Fed purposely did not give a specific timeframe in which to achieve this average. Rather, it would use its discretion to define what constitutes average inflation. Second, the Fed would allow inflation to temporarily rise in response to negative supply shocks, events that disrupt the production of goods, because a tightening policy in such instances could hurt employment. Supply-chain breakdowns due to the COVID-19 pandemic and the Russia-Ukraine war are clear examples of supply shocks contributing to rising prices.
Third, FAIT is not symmetric. At the time of FAIT’s adoption, the Fed was worried about inflation below 2%. It did not anticipate high inflation would occur the following year. As inflation grew well above 2%, many observers assumed that the Fed would then undershoot 2% to average out the overshoots. However, at a press conference in January 2022, Powell clarified that when overshoots occur, the Fed would simply try to bring inflation back to 2% rather than undershoot because undershooting requires a tougher approach to slowing down total spending in the economy. In their view, that increases the odds of producing a recession. In other words, the Fed makes up for misses from below target, but not from above—an asymmetric policy.
Even if one thinks FAIT is a justifiable policy, the framework is not easy to understand. Indeed, many economists have expressed confusion about how the Fed’s actions are consistent with the notion of producing an average inflation rate. With such a loose definition of “average,” other economists have argued that FAIT is not credible and has been a major contributor to the recent inflation surge. If NGDP targeting is hard to understand, that makes it no different from the Fed’s current system.
The NGDP Alternative
Under the proposed NGDP targeting framework, the Fed would work toward putting the sum of total spending in the economy on a predictable, stable path. When NGDP is below target, the Fed would pursue an expansionary monetary policy to bring NGDP up to target. Similarly, when NGDP is above target, the Fed would pursue a contractionary monetary policy to bring NGDP down to target.
If NGDP targeting had been in practice in 2020 when the pandemic struck, the Fed would have initially pursued an expansionary policy—as it did in reality—by cutting its target interest rate to zero and by buying different kinds of financial assets. When NGDP showed signs of approaching its pre-pandemic trendline, the Fed would then have known to tighten policy by selling assets and raising its target interest rate. To faithfully adhere to an NGDP target, the Fed would likely have had to begin tightening policy sometime in the second half of 2021, and this likely would have mitigated some of the high inflation we’re currently seeing.
Like anything new, NGDP targeting would require a learning curve for policymakers and Fed watchers. That said, targeting the total sum of spending is not an especially difficult idea to grasp. NGDP is a clearer concept than the Fed’s definition of “average inflation.” Moreover, NGDP targeting does not require the same sort of flexibility that any variant of inflation targeting requires because supply shocks are not a problem.
Under an inflation-targeting regime, when inflation rises, the Fed must determine whether that rise is due to a supply shock, a demand shock or both. While the Fed tries to avoid responding to supply-driven inflation, it is very difficult to distinguish between supply-driven and demand-drive inflation in real time. By contrast, under NGDP targeting, the Fed does not worry about whether inflation is due to supply or demand; it only worries about whether total spending is off track or not.
Addressing Powell’s Concerns
Some skeptics wonder how this alternative framework is consistent with the dual mandate because it does not directly target either stable prices or the employment level. However, NGDP targeting is like hitting two birds with one stone. Since NGDP growth is the sum of inflation and real GDP growth, NGDP targeting creates an anchor for both those variables. Inflation would fluctuate in the short run, in response to changing business cycle conditions, but businesses and consumers would be confident that it would be stable over the medium to long run. Employment is closely related to real GDP growth, so NGDP targeting also allows monetary policy to provide stability to the labor market.
This leads us to Powell’s other concern: How does an NGDP-targeting central bank handle changes in the economy’s trend growth rate? There are two options the Fed could pursue. First, it could adjust the target every few years to account for changes in trend growth. For example, suppose the Fed targeted 4% NGDP growth, and trend growth was 2%. This leaves another 2% for inflation. If trend growth fell to 1%, the Fed could then target 3% NGDP growth to keep inflation at 2%.
Alternatively, the Fed could simply allow changes in trend growth to cause a new trend inflation rate. Taking the same case where trend growth falls to 1%, the Fed would allow a new trend inflation rate of 3% to reach the 4% NGDP target. The public would likely grumble about the prospect of a higher inflation rate, but this could also pressure policymakers outside the Fed to then focus on improving the economy’s productive rate to bring the trend growth rate back up. Such reforms could include rolling back trade barriers and productivity-stifling regulations in multiple sectors of the U.S. economy.
Monetary policy is inherently a technical subject. Nevertheless, some policy options are clearer to communicate and implement than others. Right now, the Fed is trying to keep inflation at around 2% on average. While that basic idea is not too complex, the details have gotten so complicated that they’ve even confused professional economists. NGDP targeting is a simpler and less discretionary way to do monetary policy. If the Fed were to switch to NGDP targeting, it could satisfy both parts of its dual mandate in a predictable, rules-based manner and could more easily communicate its strategy to economists, financial markets and the public.