Home > Economic policy > Inflation target tyranny

Inflation target tyranny

January 27th, 2012

That’s the title of my piece in the Fin last week. As with my previous column, Catallaxy was out with a comment long before I got around to posting here, but it seemed to me to miss the point fairly comprehensively.

Ever since the first signs of the global financial crisis emerged back in 2007, the central bankers of the developed world (most importantly the US Federal Reserve, the European Central Bank and the Bank of England) having been making policy on the run, trying one expedient after another, even while insisting that nothing has really changed.

Our own Reserve Bank, buoyed by the successful management of the crisis here, is even clearer in the view that the current policy regime needs no real change. They are supported by the government, which has repeatedly rejected calls for an inquiry into the financial system, to examine whether our escape from the impact of the Global Financial Crisis was in fact the result of good management, or whether luck played an important role. Given the near-collapse of financial systems with broadly similar regulatory frameworks, such an inquiry might uncover vulnerabilities that need to be addressed before the next crisis.

The central banks of the leading developed countries failed spectacularly in the lead-up to GFC. Their failure was centred on what most central bankers still regard as the great achievement of the 1990s, the shift to a system of ‘inflation targeting’, in which the sole objective of monetary policy was to keep the rate of inflation in a target range, typically close to 2 per cent.

Inflation targeting led central bankers, most notably Alan Greenspan of the US Fed, to ignore or even applaud the unsustainable bubbles in speculative real estate that produced the crisis, and to react too slowly as the evidence emerged.

Worse still, in the post-crisis environment, achievement of inflation targets has no longer promoted stable economic growth. Rather, low  inflation has been a drag on growth. But with inflation clearly under control, central bankers like former European Central Bank President Jean-Claude Trichet have been able to describe their own performance as ‘impeccable’, even as the economies and currencies they manage appear headed for collapse.

This system is clearly unsustainable. But what is the alternative? The most popular idea begins with a change of target, from the rate of inflation, to the level of nominal GDP (the most commonly used measure of national output, valued at current prices).

The idea would be to combine a target rate of inflation (say 2-3 per cent) with an estimate of the medium-term rate of real economic growth required to maintain full employment (again 2-3 per cent is a plausible estimate). The aim would then be to keep the value of GDP, expressed in current dollars, on a growth path consistent with these targets (that is, at an average annual rate somewhere between 4 and 6 per cent).

This change would have several effects. First, it would restore the balance that used to prevail in monetary policy before the 1990s, when central banks were explicitly required to pursue full employment as well as price stability.


Second, because the target would apply to the level of nominal GDP, its adoption would require central banks to catch up the ground lost over the last few years of depressed growth and generally low inflation. That would permit a temporary increase in inflation, which is necessary if growth is to be restarted against a crushing burden of debt.

Third, the adoption of a nominal GDP target, by committing central banks to an expansionary policy would have self-fulfilling effects on expectations. By contrast, the effectiveness of past measures to expand credit has been undermined by the expectation (justified by events) that they would be wound back as soon as the immediate crisis was over.

Last but not least, a nominal GDP target would create room for fiscal policy as well as monetary policy. What is needed now is the abandonment of counterproductive austerity policies as a response to the slump in Europe and the US. Austerity should be replaced by a combination of short-term fiscal stimulus and long-run measures aimed at a sustainable budget balance. That can only be achieved if central banks co-operate with pro-growth fiscal policy, instead of seeking to counteract it in the name of inflation targets.

The abandonment of inflation targeting would, of course, be an admission of failure. But central banks have failed, disastrously, and admitting this would be the first step towards a sustainable recovery.

A system of nominal GDP targeting would maintain or enhance the transparency associated with a system based on stated targets, while restoring the balance missing from a monetary policy based solely on the goal of price stability.

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  1. Troy Prideaux
    January 27th, 2012 at 11:31 | #1

    “But with inflation clearly under control, central bankers like former European Central Bank President Jean-Claude Trichet have been able to describe their own performance as ‘impeccable’, even as the economies and currencies they manage appear headed for collapse.”

    Which reminded me of a comment just posted on Golem from Pat Flannery, although it’s aimed at Tim Geithner, you could just as well substitute other CB names:

    “Geithner kinda reminds me of the Concordia cruise ship captain. The only difference is we are all on deck cheering him on! What a merry old catastrophy this will be”

  2. Chris Warren
    January 27th, 2012 at 12:10 | #2

    Doesn’t this all boil down to one cry – for a;

    …combination of short-term fiscal stimulus and long-run measures aimed at a sustainable budget balance.

    In essence these are code words. In effect, fiscal stimulus means public debt (government spending greater than revenues). Long-run measures means ‘future generations of policy makers’.

    Unfortunately we are the inheritors of past “combinations of short-term fiscal stimulus and long-run measures aimed at a sustainable budget balance” with the results we now enjoy.

    If we want stimulus, the only way is to tax super-profits and use the funds to provide needed goods and services, such as affordable housing and possibly other Australian built goods and services.

    Housing is good because relatively few inputs can be imported (at least that was the case in the past).

    Taxing super-profits does not increase public debt, and does not cause inflation if there is under utilised capacity (ie 5% unemployment). It is the only way the government can achieve what it has promised to do – achieve surplus.

    .

  3. Gaz
    January 27th, 2012 at 13:04 | #3

    Hi prof.

    Here is my two bob’s worth.

    1) The CPI inflation target doesn’t ignore the full employment goal. In Australia, the RBA has characterised its targeting regime as “‘let the economy grow as fast as possible, consistent with the inflation target. Now you could argue that not having a target might allow a better outcome for jobs but I don’t think it’s true that they’ve abandoned an employment goal. The RBA is still legally required to pursue full employment as well as price stability. It’s there in the RBA Act, up in lights on their web site.

    2) Targeting nominal GDP instead of the CPI would run into many of the same problems the CPI target has, most notably the problem of asset price booms and busts.

    3) Targeting nominal GDP has a problem that would affect all economies but more so economies like Australia with its big export commodity sector, because exports are part of GDP.

    Consider this hypothetical example. Say you want nominal GDP to grow at 7% a year, about in line with recent outcomes) and export commodities make up 10% of GDP (also in the actual ballpark).

    Now, let’s say export commodity prices rise 40% and real output in the sector goes up by 20%. That by itself will add about 7% to GDP. So if, say, prices in the rest of the economy are going up by 2% a year, that means you have to contract the rest of the economy by nearly 2% to get to your 7% nominal GDP target.

    And by doing that, you’ve now managed real GDP growth of not much above zero. Hardly an unemployment-minimising policy.

    4) Would nominal GDP growth have been more stable under a nominal GDP target than under a CPI inflation target?

    Consider the following – Australian nominal GDP growth rates for years ending June in the inflation targeting era, bearing in mind that if you adjust for fluctuations in the terms of trade it would be even more stable especially near the end of the series:

    1994 5.1
    1995 6.2
    1996 6.8
    1997 5.0
    1998 5.8
    1999 5.7
    2000 6.5
    2001 6.6
    2002 6.8
    2003 6.0
    2004 7.5
    2005 6.9
    2006 8.1
    2007 8.7
    2008 8.7
    2009 6.7
    2010 3.3
    2011 8.2

    5) The way you (JQ) express your preferred regime seems to be more a nominal domestic demand target (real GDP plus a domestic inflation rate).

    That would avoid the export price issue, but would still look like inflation targeting. If inflation is high, you slow the real GDP growth rate down and if inflation is low you allow faster real GDP growth. That’s pretty much what we have now.

    6) Errors in policy by our RBA since they started targeting have been forecasting rather than policy framework. Like now, for example, they’ve unwound some cash rate rises because they overestimated the likely strength of the economy in the mining boom context. They would have made the some error under a nominal GDP target or a nominal domestic demand target.

    7) This isn’t to say fiscal policy should not be used to promote full employment. But that’s a separate argument. If inflation is a speed limit to growth then it is no matter what policy you’re using to generate the growth.

    The euro zone’s problem isn’t that they’re obsessing about inflation too much, it’s that they’ve denied themselves the use of fiscal policy by outsourcing their central bank and cutting off their monetising noses to spite their fiscal faces.

  4. Gaz
    January 27th, 2012 at 13:07 | #4

    Just to clarify 5 above – I say it’s more like a domestic demand target because real GDP and real domestic demand run more in parallell than their nominal counterparts.

  5. rog
    January 27th, 2012 at 13:35 | #5

    The IMF have now found evidence that fiscal consolidation leads to recessions. Seems that nobody is listening to the IMF – capital has been flowing out of the EU into safe havens for some time and the IMF appear to trying to play catch up.

  6. Gaz
    January 27th, 2012 at 14:23 | #6

    Agreed, rog. In its new world outlook this week the IMF appears alomst paranoid that fiscal policy will be tightened too rapidly. Well, it’s only paranoid if there’s nothing to worry about…

  7. rog
    January 27th, 2012 at 14:31 | #7

    Shiller has a piece out today saying

    Policymakers cannot afford to wait decades for economists to figure out a definitive answer, which may never be found at all. But, judging by the evidence that we have, austerity programs in Europe and elsewhere appear likely to yield disappointing results.

    HSBC ditto

    “…austerity does not deliver the rewards it is supposed to deliver…The consequence is that you are left with countries that have zero growth, possibly recession and interest rates which are painfully high and that combination is unsustainable.

  8. Troy Prideaux
    January 27th, 2012 at 14:39 | #8

    Careful Rog, you’re treading on religious grounds there.

  9. JB Cairns
    January 27th, 2012 at 15:33 | #9

    It is also interesting that when France and other counties were downgraded the Ratings agency made explicit that one of the reasons was that austerity leads to both debt & defcit ratios blowing out ( Numerator rising and denominator falling).

    Oliver Blanchard has found bond spreads narrow when such packages are announced but widen quite a bit when the ratios blow out because of austerity.

  10. Gaz
    January 27th, 2012 at 15:53 | #10

    That’s Olivier not Oliver, JB.

    Sigh.

    Maybe I should get a lirge.

  11. January 27th, 2012 at 21:43 | #11

    Welcome to the NGDPLPT Club!

    (Like Gaz says, I think those of us NGDPLPTers in the more open economies, especially commodity exporters like Canada and Australia, need to think a little more about fluctuations in the terms of trade. Most of the NGDPLPTers are Americans, where it’s less of an issue.)

  12. January 27th, 2012 at 22:00 | #12

    John: “The abandonment of inflation targeting would, of course, be an admission of failure. But central banks have failed, disastrously, and admitting this would be the first step towards a sustainable recovery.”

    You’ve never worked in marketing, have you?

    Try this instead:

    ‘ The switch to NGDPLP targeting would not be an abandonment of inflation targeting. NGDPLPT would be a refinement of what was always seen as the goal underlying flexible inflation targeting, by making that goal more transparent, and providing a firmer nominal anchor for long term expectations through a commitment to correcting the occasional past mistake. It is not an admission of failure, but a recognition that further improvements are desirable.’

  13. reason
    January 27th, 2012 at 23:56 | #13

    Nick,
    “need to think a little more about fluctuations in the terms of trade. ”

    Yes. And while you’re at it you might think about demographics, and resource depletion. We may want to target NGDPLP, but not necessarily have a fixed (for all time) target.

  14. January 28th, 2012 at 00:52 | #14

    reason: I think I disagree there. Debtors and creditors have long-term nominal commitments. Suppose there’s some shock to real GDP coming from the supply-side. Under Price Level Path Targeting, debtors take on all the risk of real shocks, and creditors take none. Under NGDPL Targeting, debtors and creditors share the risks. That’s probably a more stable system, as well as more efficient.

  15. Ikonoclast
    January 28th, 2012 at 06:56 | #15

    JQ writes:- “Inflation targeting led central bankers, most notably Alan Greenspan of the US Fed, to ignore or even applaud the unsustainable bubbles in speculative real estate that produced the crisis, and to react too slowly as the evidence emerged.”

    My questions on inflation are these. Why is a real estate bubble not seen as inflation? Why is a real estate bubble not measured as inflation (apparently)? Is the current measurement of inflation (in Australia) truly indicative of the inflation experienced by real consumers of the various socio-economic groups buying real baskets of goods? Does the over emphasis on inflation targeting create incentives to rig the inflation number by manipulating the basket of goods employed for the calculation?

    My questions on nominal GDP targeting of growth are these. How, in detail, would we set about actually achieving the GDP growth target? JQ says:- “Austerity should be replaced by a combination of short-term fiscal stimulus and long-run measures aimed at a sustainable budget balance.” This sounds like the beginning of a new strategy but it does not spell out what is actually required. The short run fiscal stimulus is clear enough (budget deficits) but the length of the “short run” is not specified even as a possible band. Neither are the long run measures specified nor is “sustainable budget balance” defined. After the stimulus works (and I agree it would work) would the orthodox “sustainable budget balance” simply return the economy to a condition of contraction or recession? Why should “sustainable budget balance”, orthodoxly understood, be the goal? Why should not continuing full employment be the goal even if these requires (mostly) deficit budgets? Why make a fetish of long run budget balancing? Why not accept that the long run position might require (a) persistent deficits or (b) balanced budgets or (c) persistent surpluses depending on what the real system tells us? In other words, why have a pre-conceived position on budget balances?

  16. Gaz
    January 28th, 2012 at 08:22 | #16

    Ike,

    1) Asset prices are important but they are IMHO different to goods and services prices as measured by the CPI and various indexes and deflators.

    So, if we measure nominal GDP and take inflation away then we have real GDP which has clear implications for employment and other real stuff like infrastructure needs, resources etc. But you can’t do the same thing with asset prices.

    Also as you can see from the current sporadic debate about housing prices, trying to establish a target for asset price inflation – which assets to measure, what’s the “right” level and growth rate, how do we deal with cyclical price movements, etc – is much, much more problematic than G&S inflation.

    I don’t think this is an issue that central baks are ignoring, it’s just that they haven’t figured it out yet (and they’re not Robinson Crusoe there). There was a view ahead of the GFC – even persisting after the dot com crash – that it was optimal to let the booms run and use monetary policy to clean up the mess after, rather than to try and guess whether a boom was justified by fundamentals or not. (eg Greenspan’s Dec 1996 speech re “irrational exuberance” referring to the Japanese experience, contary to popular belief).

    The GFC seems to have put that idea on ice, but coming up with a prescription to deal with asset prices – I don’t see a rule-based policy on the horizon.

    2) I think your thoughts about manipulating the basket of goods in the CPI is off the mark. I’ve had a fair bit to do with the ABS over the years and I reckon they’re straight-shooters. If they were the kind of people to fudge the data they’d be working in investment banking, lobbying or advertising and making a lot more money. Anyway, the lead time for rearranging the CPI basket is measured in years, not amenable to political tinkering. BTW there are indexes for various sub-groups of households – have a browse through the “related information” link in CPI (6401.0) part of the ABS web site.

  17. Troy Prideaux
    January 28th, 2012 at 09:05 | #17

    Gaz, thanks for your input – you obviously know this stuff and your explanation makes a lot of sense. However, I can’t see what the problem is (conceptually at least) in trying to target asset – or more specifically housing – prices to reasonably align with CPI?

  18. Chris Warren
    January 28th, 2012 at 09:12 | #18

    Maybe it is not possible to target GDP. If we do not know the value of money, the size of the labour force, or economic conditions in other countries, over the next quarter, targeting GDP is pointless.

    The whole concept that Reserve Bank boffins can adjust levers for any targeted outcome without worsening the rest, is Ptolemaic stupidity.

    The ABS can only tell you what happened in the past, and any policy based on this is usually reduced to rubble by the next occurring turning point (in any data series) or gaming strategy by investors. Wisely the ABS gave up its pretensions in this forecasting area when it ditched its “Composite Indicator” exercise.

    You cannot target inflation or GDP, or unemployment, if you do not target profits.

  19. TerjeP
    January 28th, 2012 at 09:19 | #19

    Inflation targeting led central bankers, most notably Alan Greenspan of the US Fed, to ignore or even applaud the unsustainable bubbles in speculative real estate that produced the crisis, and to react too slowly as the evidence emerged.

    The US fed never explicitly had a policy of inflation targeting. There was much debate in the early part of the 2000′s about suggestions that they should adopt such an approach. In the end the advocates lost and the US continued instead with it’s mixed approach in what might be called the Greenspan standard.

    Just to prove there was a debate for those that were not paying attention at the time I’ve plucked a paper form Google. Please note I don’t agree with the paper I merely share it to make the point that the debate was very much alive.

    http://www.economics.harvard.edu/files/faculty/20_Why%20the%20Federal%20Reserve%20Should%20Not%20Adopt%20Inflation%20Targeting.pdf

  20. TerjeP
    January 28th, 2012 at 09:28 | #20

    Nominal GDP can easily grow at between 4-6% if inflation is say 14-16% and real GDP growth is negative 10%. As such targeting nominal GDP at 4-6% is entirely consistent with stagflation.

    If high inflation was a cure for low or negative growth then the 1970s would have been an economic boom.

    Europe is not in crisis due to a lack of inflation. And adding inflation to the mix will make things worse not improve them. Greece for example is in crisis because the government has borrowed beyond it’s means and must now cut back the public sector. It’s private sector can’t pick up the slack because it is riddled with silly rules and taxes such as a 28% payroll tax and ridiculous laws around dismissing employees. The cure is microeconomic reform not inflation.

  21. Gaz
    January 28th, 2012 at 12:41 | #21

    Troy – The question is why would you want to target housing prices. What would be the goal of such a policy? Would it help to, say, achieve full employment or reduce volatility in output and employment?

    Chris – You touch on an interesting point in your final paragraph. If you target CPI inflation, you are effectively targeting wages growth because that’s the major influence (given productivity growth and import prices) on domestic prices. But if you do that, it means the benefits of a mineral price boom accrue to profits. We see that now with a record high profit share of national income with wages typically described by economists as “well behaved”. No-one is describing profits as “badly behaved”. The share of mining revenue accruing to Australian is certainly badly behaved, as you would expect when you let foreign businesses dig your country up for peanuts.

    Terje, microeconomic reform will cure Greece’s macroeconomic crisis? This is the sort of reasoning that would attract, say, 0.4% of the vote in Bennelong.

  22. TerjeP
    January 28th, 2012 at 13:48 | #22

    Gaz – 0.4% is more than you got.

  23. Tim Peterson
    January 28th, 2012 at 14:52 | #23

    The problem with NGDP targetting is that you have to claw back inflation overshoots:an ultra hawkish policy.

    The best approach is the Taylor rule, which combines a level target for real GDP with a rate of change target for prices. The Fed, through the great moderation, seems to have used the following Taylor rule:

    Cash Rate=4%+1.5*(Inflation-2%)+0.5*output gap.

    If you want to put more emphasis on output, you can up the coefficient on it.

    Most inflation targetting central banks in reality are using some variant of the Taylor rule.

  24. Ernestine Gross
    January 28th, 2012 at 16:20 | #24

    I agree with those who consider terms such as ‘stimulus’ and ‘austerity’ being worse then useless; they tend to appeal to the emotions (fear or confidence mongering) and wrongly suggest that the complexity of the global economy can be boiled town to these two words.

    I also agree with those who say that nomial GDP targeting is not helpful to adress the varied problems in the global economy even when this ‘global economy’ is artificially reduced to ‘the US’ and ‘the EU’.

    I have 2 specific questions:

    a) How would GDP targeting match with reducing green house gas emissions in a Kyoto framework (where, unfortunately, ‘costs’ are measured in GDP terms)?

    b) Why are the officials of central banks criticised (outside the US)*)? Is it not the case that the institutional framework in EU countries as well as in Australia is determined by elected governments?

    To the best of my knowledge, the answer to my second question in this paragraph is YES. Governments set the institutional framework. Governments design ‘job descriptions’ (including performance targets) for their institutional delegates. Hence, the heads of central banks, who achieve their set targets, are right in saying that they have done well. Where am I wrong?

    *I am not clear on how things work in the US. At times it seems as if Wall Street is delegating to the White House with job descriptons provided in the mail or in meetings. But, I may be totally wrong on this one.

  25. Troy Prideaux
    January 28th, 2012 at 17:18 | #25

    Gaz :
    Troy – The question is why would you want to target housing prices. What would be the goal of such a policy? Would it help to, say, achieve full employment or reduce volatility in output and employment?

    Mostly for housing affordability reasons. We seem to be the western leaders in household dept which is non-trivially influenced by housing affordability. Artificial housing booms might not necessarily require direct intervention, but the option should always be available and intense scrutiny of such situations should be standard practice IMHO.

  26. Tim Peterson
    January 28th, 2012 at 17:19 | #26

    I meant to say NGDP _level_ targeting.

  27. Gaz
    January 28th, 2012 at 17:52 | #27

    Troy,
    I guess that’s an illustration of the probelm with asset price targeting. What if unemployment was higher then desired and rising, but housing prices were judged – by some yardstick – to be too high. Which takes second place – creating jobs or making housing cheaper for those lucky enough to have one?
    I don’t have the answers but adding housing or share prices (or the prices of CDOs or RMBSs or antiques) to the stuff central banks already have on their plates sure adds a head more questions.
    Maybe housing is more suited other arms of policy. Or you’d need a central bank with more levers to pull than they have at the moment. Even then, they’d end up in the position of having to decide which sectors of the economy to stimulate (sorry Ernestine) and which to constrain. That would put central banking in front and centre of politics. Much more so than now. The structure of the RBA’s board would be totlally untenable in its current form too.

  28. Chris Warren
    January 28th, 2012 at 19:11 | #28

    @Gaz

    Profits have increased dramatically.

    The increase of Surplus of Financial Corporation as a percentage of Wages and Salaries is extreme.

    It was less than 5%, in the 1980′s, but is now over 10%.

    See ABS:5206 table 7 (A2302399K, A2302405V).

    It appears profits are more of a problem than wages.

  29. sdfc
    January 28th, 2012 at 20:04 | #29

    NGDP growth should be the target for the cash rate in as much as the cash rate should not be kept too far from NGDP growth. This is an old theory I know but the money rate of interest should be kept as much as possible with the natural rate of interest with NGDP growth as a proxy.

    The 70s inflation and the pre-GFC credit bubble are prime examples of what happens when thecash rate is held below NGP growth for an extended period.

    As for the RBA keeping the cash rate below NGDP for an extended period has left houshold finances in a precarious position.

  30. sdfc
    January 28th, 2012 at 20:07 | #30

    I’m talking in the longer run of course.

  31. Troy Prideaux
    January 30th, 2012 at 07:42 | #31

    @Gaz
    Agreed. It’s certainly not the RBA’s role to intervene in such areas. Apologies for the confusion.

  32. Gaz
    January 30th, 2012 at 09:17 | #32

    Don’t get me wrong, Troy. I’m not of the view that the RBA should operate only using its control over the interbank cash market. It’s just that it can’t do much else in the current setup, with this somewhat arbitrary boundary between fiscal and monetary policy.

  33. JB Cairns
    January 31st, 2012 at 10:36 | #33

    SDFC,

    I cannot see the point of such targeting.

    when the economy is ‘normal’ targeting inflation remains the most important issue.
    In times such as now in the US where there is clearly a liquidity trap monetary policy is problematic. In essence you do not want it to be contractionary but apart from that it will not be usual until the liquidity trap is no more.

    you need fiscal policy to get back to ‘normal’ growth. In the long term you need it it to be constraining the economy so the private sector can grow more.

  34. Sleetmute
    February 1st, 2012 at 10:23 | #34

    “Last but not least, a nominal GDP target would create room for fiscal policy as well as monetary policy.”

    This is precisely wrong. A NGDP target would make fiscal policy even more impotent than it is already. Fiscal ‘austerity’ is facilitated by NGDP targeting because the central bank would even more vigorously than now offset any austerity with more monetary easing. Scott Sumner and Lars Christensen have made this point repeatedly.

  35. Graeme Bird
    February 2nd, 2012 at 20:04 | #35

    Consumer-price-inflation targeting is a ludicrous superstition. The tail wagging the dog with metrics three stages removed from core.

  36. sdfc
    February 3rd, 2012 at 19:05 | #36

    JBC

    The current system has seen central banks ignore the sharp rise in credit in favour meeting the CPI inflation target.

    If the cash rate is held below the natural rate of interest for an extended period then you set yourself up for an inflationary boom. History shows this to be true. Low interest rates distort decision making. Asset price inflation should not be dismissed as irrelevant.

    As I said I’m talking about an economy at or near full employment and not advocating higher interest rates in the current environment.

  37. andy
    February 6th, 2012 at 16:29 | #37

    Hi John,
    I am interested in NGDP targeting. One comment I have is that John Taylor wrote recently (in Getting Off Track) that in his view the gfc was caused by central banks not sticking with the Taylor Rule (i.e. they used discretion over rules). He makes the case that if they stuck to the Taylor Rule then the ‘bubble’ wouldn’t have occurred. If we accept Taylor’s work then doesn’t NGDP suffer from the same weakness (i.e. the weakness that the central bank can ignore it whenever they want and use discretion)???

    Secondly, if we can’t trust central banks to get this right why don’t we follow the George Selgin route to free banking?

    Now I assume that you’re going to say…that’s too hard…too much change…will never happen. I accept that might be correct but that isn’t necessarily a reason not to pursue it. Would be interested in your thoughts…if not free banking…why not the Friedman rule of growing monetary base at a fixed rate??

    many thanks – A

  38. David
    February 7th, 2012 at 11:12 | #38

    “The idea would be to combine a target rate of inflation (say 2-3 per cent) with an estimate of the medium-term rate of real economic growth required to maintain full employment (again 2-3 per cent is a plausible estimate).” The problem I see with this is the central bank can’t influence real economic growth in the long term. That comes from fundamental factors such as productivity growth. If you make the HUGE assumption that 2-3 percent over the long run is a given then this approach might work as you get an automatic monetary boost when real GDP slows and a monetary contraction when real GDP expands. But long run GDP growth can’t be the central bank’s responsibility as they have no influence over it. People believed they did for a while (aka “The Maestro”) but that doesn’t make any sense and proved to be wrong in any case – they are just a central bank.

  39. Sleetmute
    February 7th, 2012 at 11:24 | #39

    David, it’s true that the central bank can’t influence real economic growth in the longer term – market monetarists don’t disagree with that proposition. But real growth over multi-decadal time horizons has been fairly steady in the US and Australia. Even if it changes from, say, 3% to 2%, this would mean just 1% higher inflation a year – hardly a major problem. In any case, consumer price indices and various deflators are all artificial constructs themselves. Who knows what ‘inflation’ really is or means given the various assumptions that are made about quality and baskets and weightings? One thing the central bank can clearly do is influence nominal spending – the components of this (real growth, inflation) are influenced greatly by assumptions and conventions.

  40. Troy Prideaux
    February 7th, 2012 at 12:22 | #40

    David :
    But long run GDP growth can’t be the central bank’s responsibility as they have no influence over it. People believed they did for a while (aka “The Maestro”) but that doesn’t make any sense and proved to be wrong in any case – they are just a central bank.

    I’m not sure I’d use such definitive statements as that. GDP and productivity often are influenced by investment and the decision to make the investment is often influenced by the cost of the investment. What’s more, the cost of the investment can also have wide ranging secondary implications such as further investment and capital expenditure.
    I’m not trying to overstate the RBA’s potential influence on long term GDP growth, but to say it has no influence sounds a bit strong to me.

  41. Dan
    February 7th, 2012 at 12:40 | #41

    Agreed. Subject to a bunch of caveats, and putting liquidity traps aside, low rates => lower capex costs => greater mechanisation etc. => greater output per worker (ie. productivity).

  42. sdfc
    February 7th, 2012 at 18:42 | #42

    => high asset price inflation => rising credit growth => fragile economy.

  43. David
    February 7th, 2012 at 18:59 | #43

    @Dan
    Remember there are 2 sides to lower rates. I could just as easily argue low rates => less incentive to save and invest => less mechanisation => less output per worker (ie. productivity).

  44. Troy Prideaux
    February 7th, 2012 at 19:36 | #44

    David :
    @Dan
    Remember there are 2 sides to lower rates. I could just as easily argue low rates => less incentive to save and invest => less mechanisation => less output per worker (ie. productivity).

    David,
    to invest in either greater production capacity or an increase in potential productivity more often than not costs money. Nearly always, it’s *borrowed* money ie. subject to interest rates. Even if it was from cash reserves, lower interest rates does indeed relate to less incentive to save, but how does that relate to a less likelihood of investing ie *spending* on productivity?

  45. David
    February 8th, 2012 at 09:29 | #45

    Troy Prideaux :

    David :
    @Dan
    Remember there are 2 sides to lower rates. I could just as easily argue low rates => less incentive to save and invest => less mechanisation => less output per worker (ie. productivity).

    David,
    to invest in either greater production capacity or an increase in potential productivity more often than not costs money. Nearly always, it’s *borrowed* money ie. subject to interest rates. Even if it was from cash reserves, lower interest rates does indeed relate to less incentive to save, but how does that relate to a less likelihood of investing ie *spending* on productivity?

    In a closed economy savings = investment. In an open economy things are more complicated but high rates of saving will still be closely related to high rates of investment. How interest rates influence savings and investment decisions is debatable of course – in theory it should attract savings and reduce the number of value adding investment opportunities and the market for money clears. So there is a rate that is optimal but it isn’t necessarily a low one.

  46. David
    February 9th, 2012 at 09:33 | #46

    When does my last comment clear moderation? (new around here)

  47. David
    February 9th, 2012 at 09:43 | #47

    I’ll try a repost without all the quotes – See if that works

    In a closed economy savings = investment. In an open economy things are more complicated but high rates of saving will still be closely related to high rates of investment. How interest rates influence savings and investment decisions is debatable of course – in theory it should attract savings and reduce the number of value adding investment opportunities and the market for money clears. So there is a rate that is optimal but it isn’t necessarily a low one.

  48. Troy Prideaux
    February 9th, 2012 at 10:14 | #48

    David,
    Hehe, good to hear I wasn’t the only one whose post was moderated – must be a software thingy.
    As for “investment”, I was simply using the common interpretation used by business as I was basically referring to business as the primary mechanism for the point I and Dan was trying to make. The interpretation was as per Wikipedia’s explanation of “investment” under the “economics” or “business management” subsections. I understand this can be ambiguous term and I apologize for any confusion.

  49. Dan
    February 9th, 2012 at 10:58 | #49

    sdfc :=> high asset price inflation => rising credit growth => fragile economy.

    Yes, that’s Minsky’s Ponzi stage.

    David – yes, I too was assuming that business investment was bankrolled with lending finance.

  50. David
    February 9th, 2012 at 12:22 | #50

    OK – I’m talking about investment in a macroeconomic context. I don’t think central banks have anything to do with long term growth EXCEPT maybe the connection between price stability and growth (textbook costs for inflation – sticker costs, difficulty to make nominal contracts, etc). So I guess the risk is if they target a nominal GDP growth number then the actors in the economy that matter (workers, business, capital) may forget what real growth is all about. Maybe that happened already pre 2007 in the United States? Fake wealth via monetary expansion and house price inflation led people to forget about real value?

  51. Dan
    February 9th, 2012 at 12:55 | #51

    Haha: again, yes, that’s Minsky’s Ponzi stage. And it comes just before a crash.

  52. Troy Prideaux
    February 9th, 2012 at 13:30 | #52

    @David
    “OK – I’m talking about investment in a macroeconomic context”

    Then I think your interpretation of “investment” is wrong.

    http://en.wikipedia.org/wiki/Investment

  53. Gaz
    February 9th, 2012 at 16:28 | #53

    I’m not sure I agree with the idea that the central bank can’t influence growth in the long run. I tihnk it’s fairer to say the central bank can’t make the economy faster than some limit deternmined by labour supply and productivty over the long run, but it can sure make it grow slower than that limit over an extended time frame.

  54. Dan
    February 9th, 2012 at 16:40 | #54

    Yeah, I think that’s almost laughably obvious – suppose the RBA cranked rates to 50% tomorrow. That would put the brakes on capex well and truly (and have some bizarre second-round effects). Hence, from a purely logical perspective – no economics required – you can say the RBA is influencing economic growth.

  55. David
    February 9th, 2012 at 17:44 | #55

    Troy – Which part of the Wiki link are you referring to? Plenty of definitions in there so tough to be so categorically wrong! See the section “In Economics or Macroeconomics” and that is what I am talking about.

  56. David
    February 9th, 2012 at 17:52 | #56

    Dan and Gaz – Yes, I take your point they could sabotage the economy and pull growth down by doing silly things and this wouldn’t necessarilly be short term – they could do it for a long while. I suppose any major actor in the economy could do that (unions?). But actually driving growth (i.e. creating real wealth) is well above their capabilities – its driven by fundamental drivers.

  57. Troy Prideaux
    February 9th, 2012 at 19:12 | #57

    @David
    David,
    That’s exactly what I was referring to.

  58. Dan
    February 9th, 2012 at 19:41 | #58

    @David

    ‘pull growth down by doing silly things… they could do it for a long while.’ Not just. They could alter (and have altered) the economy’s trajectory altogether. It’s been estimated that it took 10 years to recover from the Recession We Had to Have.

    As for creating real wealth – I’m still of the opinion that they fulfill the crucial role of setting conditions/parameters for the creation of real wealth (or fake wealth for that matter, and I think being able to tell the difference is the art and science of the central banker).

  59. David
    February 9th, 2012 at 21:29 | #59

    Dan – I could agree with that. Well said.

  60. Dan
    February 9th, 2012 at 23:07 | #60

    Cheers – and it got me thinking about how all this worked before central banks were established. Can anyone either enlighten directly or direct to something enlightening?

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