Got an Idea?
Proposition: "The Reserve Bank of Australia should be tasked with targeting nominal economic growth rather than inflation."
This objective is too crude. For example, it implies raising the bank rate when real growth increases and the inflation rate is constant, which may not be appropriate. The criteria for the RBA should be more nuanced.
A target in terms of real economic growth would be a reasonable alternative to a target in terms of inflation for it is real economic growth that delivers the goods to support a improved standard of living. Of course, whether the RBA is able to exert more than a weak and indirect influence on either the inflation rate or real economic growth is open to serious doubt.
In my view this is question of the right assignment of policy instruments. Monetary and fiscal policy both have important (separate) roles in macro-economic management, with monetary policy most appropriately assigned to inflation, not inflation and real growth together. This assignment is not without absolute qualification - performance against an inflation target range should also have regard to key real economy indicators such as the rate of unemployment.
The RBA (or any central bank for that matter) should certainly not be tasked with targeting long-term growth (nominal or real). This is such a well established result in the academic literature and policymaking practice that I do not think anyone can realistically argue the opposite. If instead we refer to the short-term, then the RBA might play a role in stabilizing output; that is, in using the monetary policy instrument counter-cyclically to smoothen cyclical fluctuations. But even then, this does not mean targeting nominal growth rather than inflation. Finally, the RBA has already done a lot to stimulate the business cycle in this phase of contraction. Further interest rate cuts are unlikely to have any significant impact on output. Instead, it is now up to the government to do more to support the recovery and, even more importantly, to create conditions for sustained long-term growth.
It is hard to know what the point is with respect to this suggestion.
Nominal income growth is the product of inflation rate and real output growth. Higher values of one are bad and of the other are good. So why combine in one "target' rate range - where the policy response should depend on the mix.
An optimal approach would be for the RBA to consider economic growth, inflation and unemployment in setting policy.
Given how difficult it is to set long term goals for any part of government, I believe it would be a mistake to change the focus of the RBA from inflation to economic growth. Nominal economic growth seems to be a mistake for sure. The reason for the lower level of confidence and the "disagree" instead of a "strongly disagree" comes from the fact that with a short-term perspective, it may make sense in the current situation to consider changing targets for a limited time. Again, I feel the political process is beyond short term changes. In that respect, I feel the suggested alternative cannot be supported.
From a theoretical point of view, targeting the path of nominal income makes a lot of sense (for the reasons outlined by prominent monetary economists like Mike Woodford, amongst others). In particular, such a target implies an important degree of "history dependence" (e.g. you can have more expansionary policy going forward to make up for past mistakes, etc). I should note at this point that a nominal income growth target (as stated in the poll question) does not have these theoretical benefits and is a more contentious suggestion. Putting the distinction between level and growth targets aside, my guess is that the magnitude of the gains from moving from a flexible inflation target like we have to a well-functioning nominal income target are likely to be fairly small. From a practical point of view, there are a host of tricky implementation issues that would have to be addressed and that would likely diminish the gains from changing the monetary policy target. For example, for a small open economy like Australia it would be untenable for monetary policy to respond to high-frequency nominal terms of trade movements (which are notoriously volatile). We would end up having to target some notion of "core nominal income" to strip out such volatility. In short, my view is that in practice such a change is unlikely to yield large gains for society. Indeed, many of the concerns with the existing inflation targeting regime (the current proximity to the effective lower bound on nominal interest rates; scepticism about the efficacy of conventional monetary policy, etc) would be of much less concern if fiscal policy was doing its job. That's where the focus should be.
Nominal growth can vary naturally for reasons you would not want to adjust interest rates for, such as a greater influx of migrants or unexpected costs due to natural disasters. So nominal growth targeting makes little sense in principle. Besides, the ability of the RBA to influence growth with the current paltry instrument set should not be over-estimated. To improve growth, the RBA should aim for competitive neutrality in how it treats citizens and private banks: currently it helps private banks make huge profits by unfairly excluding the general public from the favourable lending conditions it gives to private banks. That unfairness has lead to uncompetitively high levels of interest rates charged to small business and mortgages, depressing the economy. The RBA can affect the growth rate much more by stopping its favouritism towards the private banks than by any tinkering with the interbank rates.
Being flexible in terms of examining wider economic conditions as well as inflation targets is reasonable, but the main focus of the central bank is usually the inflation rate.
Uncertain (neither agree nor disagree)
Targeting inflation is superior to targeting nominal GDP, although the current target band of 2-3 per cent needs to be revised downwards, to 1-3 per cent. One weakness of targeting nominal GDP is that it would lead to excessively low interest rates whenever there was a secular decline in the rate of growth of real income. Indeed, this kind of secular slowdown currently bedevils our economy. Another weakness is that monetary policy would probably be excessively anti-cyclical. At the peak of commodity booms, for example, we would see a severe 'Dutch disease' effect bearing down on non-commodity exports and import-competing industries, e.g. education, tourism, property, financial services and manufacturing They would face very high nominal and real exchange rates, leading to excessive rotation through the cycle of resources in and out of sectors producing non-commodity tradables.
Central Banks appear to be quite good at targeting inflation. They seem to be really bad at targeting real GDP. The illusion that some central banks have been achieving steady results in nominal GDP(implicit targeting nominal GDP) may just be a result of their success with the inflation component of nominal GDP. Inflation targeting has been a success. The period of inflation targeting since the early 1990's has given Australia its longest period without recession .At the current rate of decline, unemployment should fall below the natural rate of around 5.3% no later than 2017. Notably, Australia has avoided the severe recession after the resources boom that befell Brazil and some other resource rich countries. '"This wheel ain't broke". We have no reason to fix it.
Central banks need to pay attention to both inflation and economic activity. The advantage of a nominal income rule is that it would provide the RBA with greater certainty as to how to balance the dual mandate. In Australia the Bank has always been willing to tolerate swings of the inflation rate outside the nominated band when it judges that is appropriate to support activity. So the question really comes down to whether we should impose a rule in place of allowing the Bank discretion. Generally I prefer discretion to rules.
To the extent that targeting nominal GDP growth makes inflation more variable, and hence unpredictable, this would adversely affect inflation expectations. If under these circumstances nominal interest rates do not properly reflect future inflation, this would generate unwelcome arbitrary income redistribution between lenders and borrowers since real market interest rates would more likely be distorted. It would also obviously require forecasting both inflation and real GDP growth. In light of the poor record of official GDP forecasting, this would increase forecast risk and make implementing monetary policy far more challenging than under inflation targeting. The issue of which real GDP measure to use also arises ie whether it is the expenditure, output or income measure, the average of these, or real gross domestic income RGDI (terms of trade adjusted GDP) which is highly variable reflecting the inherent volatility of commodity export prices.
There is a large theoretical and empirical literature going back over five decades that supports this proposition. The problem is that the best monetary regime depends on the nature of the economic shocks impacting an economy. Thus no monetary regime is always best for all shocks. However nominal GDP targeting has been found to be best in most cases and particularly relative to inflation targeting when responding to supply shocks (i.e. productivity shocks) and changes in country risk. More information here.
A nominal GDP target is effectively a price level target (since the RBA cannot control real GDP in the long run). Such a target would be harder to communicate to the general public (and, therefore, shape their expectations) than an inflation target. It is also more sensitive to measurement problems than an inflation target. An inflation target that is achieved over a 1-3 year horizon is easier to communicate and implement. So I would recommend sticking with what has been a very successful policy framework rather than adopting this proposed alternative.
The original act establishing the RBA (end of 1950s) had a focus on objective of ensuring full employment (as well as stability of the currency ). The current inflation target reflects response to changes in the theoretical dialogue about the limitations and transmission mechanisms of monetary policy coupled with contemporary policy concerns of the 70s, 80s and 90s. Once adopted the inflation target may be said to have served Australia quite well. However, from the perspective of this history that ability to consider the changing dialogue and policy environment has been a strength of the RBA. The policy issues of this decade do require a re-consideration of both the role and targets of monetary policy. Nominal economic growth may be that target; however, of itself I cannot see that as a way out of the current impasse of low investment and productivity growth.
Globally, the inflation target system adopted almost universally in the 1990s, in combination with strong versions of central bank independence and exclusive reliance on monetary policy has been a failure nearly everywhere. Australia has done better than most, but has below-target inflation and interest rates approaching the zero lower bound. Adoption of a nominal growth target would imply a need to employ fiscal as well as monetary policy, and for a return to the pre-1990s approach to co-ordination of fiscal and monetary policy
In arguing in favour of Senator Xenophon’s proposal, Greg Jericho said: “Targeting nominal GDP resets the conversation.” I too want to reset the conversation – and I disagree with the proposal because I fear it would fail to do so. There is a case to be made in favour of NGDP targeting; and I accept that it might have been a difference for the better before and after the GFC. But, as ever, the answer to the question depends on the context. And the present context is that – as the RBA and central bankers around the world have been attempting to communicate in subtle and not-so-subtle ways – monetary policy is being asked to do way too much even as fiscal policy and other relevant policy tools have been missing in action. The result of this coupling has been a failure to revive demand and growth in tandem with a force-fed increase in asset prices and consequent wealth inequality. We cannot undo the past; and it is probably too late to halt the current downturn in growth before it takes us into recession. But the task ahead is to ensure that governments respond with appropriate action rather than continued inaction: in particular, with a manifold increase in public investment (in infrastructure, urban planning, renewal of energy and transport systems, education and training, the R&D required to realise the full potential of new technology – the sum of investments with high social returns is massive). The “great moral challenge”, to borrow a phrase, is to use public debt to increase public investment so as to bequeath a more expansive future for our “children and grand-children” – rather than scorn the gift that the world’s savers are offering governments at a price of near-zero. It is governments, not central banks, who need to be tasked anew.
A nominal output growth target could be only a little smarter than an inflation target. But both are poor choices. If both inflation and real output growth rise (fall), the economy is likely to be overheating (overcooling!) from a real demand shock. However in this case, the optimal monetary response is to the real output growth shock alone. If higher (lower) inflation is matched by lower (higher) real growth, it is likely that the cause is a supply shock. In this case, if hiring frictional costs are small, it is optimal to respond more to real output growth than to inflation. Only with unrealistically large hiring costs does the inflation target become optimally useful. Thus in a Taylor rule, the optimal weights on inflation and real growth will strongly favour the latter. Simply targeting only inflation or only nominal growth is definitely sub-optimal. This conclusion applies for DSGE models with rational or animal spirits expectations of inflation. If you want more proof, read this article.
Inflation targeting has been a successful policy in controlling inflation. It only works if the central bank adheres to the policy and, in particular, does not deviate from it when 'convenient'. While inflation is not currently an issue, it is unlikely expansionary monetary policy would dramatically increase the real growth rate. Overseas experience suggests it would not in the current conditions. Abandoning inflation targeting would thus reduce the future ability to control inflation when macro conditions change, without yielding any substantial current benefits.
It is clear to me that inflation will be very low for some time in Australia and at global level. Consequently, it is time to start discussing other monetary policy targets (amongst others nominal GDP).