The hottest idea in monetary policy circles over the last couple of years has been the notion that the Fed could induce a better recovery by stating a target for Nominal GDP.
The idea (which has been endorsed by economists like Scott Sumner, David Beckworth, Michael Woodford, Christina Romer, and others) is premised on the idea that if the Fed can set aggressive expectations for its actions, and commit to letting inflation run “hot” for periods of catch-up Nominal GDP growth, then economic participants will adapt to this forecast.
Although the idea is very buzzy in academic circles, it hasn’t quite broken through yet to the Federal Reserve itself, although the Fed did to a lot this year in terms of experimentation with guidance and easing, most notably adopting “Evans Rule” which commits to low rates until unemployment hits 6.5%, or inflation expectations surpass 2.5%, at which point the Fed may re-assess.
But in a new note out today, Goldman’s Jan Hatzius and Jari Stehn say that one Fed official has already endorsed Nominal GDP targeting in all but name, and that nobody has really realised it yet.
That official is SF Fed Chief Janet Yellen, who is thought to be one of the top contenders for Bernanke’s replacement.
Hatzius and Stehn write:
…Fed officials appear to be contemplating an even bigger shift. This is evident from a series of speeches given by Vice Chair Janet Yellen in 2012 that presented simulations with the Board staff’s large-scale econometric model, FRB/US, using an “optimal control” approach to monetary policy. Under such an approach, the central bank chooses a path for the federal funds rate which best meets its objectives over the next several years as a whole, even if this means committing to a policy that may appear suboptimal at certain points along the way. For example, the chosen path may imply that in 2013, the Fed expects inflation in 2015 to be above its target but nevertheless commits to refraining from an aggressive monetary tightening at that point. Economist Paul Krugman has referred to this approach, approvingly, as “credibly promising to be irresponsible.”
So far, no sitting Fed official has publicly called for an NGDP target. But Yellen’s optimal control approach is equivalent to a specific form of such a target. To our knowledge, nobody has pointed this out yet, although it is at least implicit in the academic literature on this issue. In a highly stylised model, Woodford has shown that the optimal policy at the zero bound is an NGDP target. In a simulation that also uses FRB/US—as does Yellen’s optimal control work—San Francisco Fed President John Williams and Fed economist David Reifschneider have shown that the optimal policy at the zero bound responds not only to current inflation and unemployment gaps but also their cumulated history. In other words, the optimal policy at the zero bound in FRB/US does not look like a Taylor rule but resembles an NGDP target.
The basic gist is: A nominal GDP target commits to periods of overly-hot inflation (irresponsibility) in order to get to a certain target.
And according to Goldman, Janet Yellen has basically endorsed the same thing, with the same economic consequences.