Saturday, January 23, 2021

Coffee Beans, Copper and Monetary Policy, Oh My!

NGDP targeting? Inflation? Nominal Wages?
Let's take a step out of the academic world. In my opinion these policies are functionally similar and the competence of the monetary authority is what is at play. Establishing a make-up policy is more important.
Say the monetary authority determines the interest rate,
Interest Rate = 4 + 3(inflation - target) + 1(output gap)
Let's take one step back into the academic world. Under an inflation targeting regime, the output gap coefficient would be zero. Now let's take one step out of the academic world. Our monetary authority wouldn't completely ignore the output gap. They wouldn't ignore any piece of data that they think would relate to their decisions to execute a "sound" monetary policy. Hence the phrase, "flexible [insert target] target" where the monetary authority will look to a wide variety of variables to determine the current stance on monetary policy. 
Perhaps you're the monetary authority in Costa Rica, the price of coffee or bananas may be of importance. Perhaps you're the monetary authority in Chile and you want to put weight on the price of copper. Perhaps you're the monetary authority in Singapore and you want to put weight on the exchange rate.
This is often a critique against restrictive monetary regimes, as done by Svensson here on NGDP targeting. 
Recall the equation above, 
Interest Rate = 4 + 3(inflation - target) + 1(output gap)
A nominal GDP target would replace the output gap term with an output growth term and the coefficients on inflation and output growth would be equal - this puts weight on the variable measuring real activity in contrast to an inflation target. Let's take a step back into the academic world. In his paper, Svensson contends that NGDP is too restrictive and while concerns may be valid these concerns aren't functionally different to me once we take a step back out of the academic world. While we're still in, the NGDP target restricts you from looking at variables that aren't inflation and output growth and says that you put equal weight on both of them. As said above, you might want to be flexible, you might want to care about other things and a flexible inflation target would be better. Now, with a foot back out of the academic world, all central banks are always "flexible." Central banks will always take in a large amount of data and go through a process of determining the stance of monetary policy. A restrictive rules based approach isn't going to happen. Even given this, it isn't clear to me that the differences in targets would actually produce drastically different results when observing monetary choices and the competency of the monetary authority at a given point in time.
NGDP still has value:
- Monetary policy is, in large part, about expectations. The relative simplicity of NGDP, or better phrased, "targeting a growth in nominal income", makes setting expectations easier. I mean, just listen to Fed officials talk about the future under it's current inflation targeting regime.... Set up the actual NGDP path and the target path and communicate what you're doing with rates relative to the gap. The two values under an NGDP target are easily observed which contrasts with the unobservable values put into the Fed's reaction function. 
- Selgin and Sheedy write about market efficiencies that would be associated with a NGDP target. Selgin writes about "credit-debtor justice", and in his paper he summarizes how a NGDP target would increase allocative efficiency by allowing for a more counter-cyclical policy while an inflation target would decrease it. Sheedy shows that various households do not have access to financial tools that would help them deal with unexpected shocks to their nominal income. (Something, something 400 dollars...) Firms and various industries do have access to these financial tools and they can equity finance instead of debt finance. A monetary policy that allows for a more counter-cyclical inflation, such as a NGDP target, aids this issue by decreasing the real interest rate on household debt when real output is low.
- By giving inflation and output equal weight, NGDP targeting signals what to do during a supply shock. Other monetary regimes make this less obvious, The simplicity and clarity of equal weights has a bigger priority, in my opinion, over small changes to find theoretically optimal tradeoffs, especially since NGDP is probably "good enough", in many models. Also, models play off the real world, and since we don't perfectly model the real world... we're fine! Factor this into the fact that central banks are inherently "flexible" as said above, and you see why these policies are functionally the same with one step into the real world.
Now, any regime has critiques and I think the critique below of NGDP targeting is valuable, but fixable. (Politics aside)
NGDP Growth = Inflation + Real Output Growth
We know that real output growth tracks productivity growth over the long run. (Btw, listen to this!) If productivity growth is low over a decent stretch of time, for any given NGDP target, inflation would be high. However, we can also change the target every few years. We might set a rule where we update our target every X amount of years based on productivity and overall macro trends.
Recall our equation above, 
Interest Rate = 4 + 3(inflation - target) + 1(output gap)
A level target would replace all growth rate terms with "level-deviation" terms and it's easy to see why a theoretical make-up policy has bigger implications in the real world.
The Fed's new AIT isn't exactly a level target, but it is a form of make-up policy and we're the implications of that right now.
Now, what's the real point of this post? Everything and nothing. Lots of these distinctions don't matter. Some of these distinctions can matter more than others. Really, the point of this post is just me saying this:
- The target in of itself probably isn't functionally different in a real world despite many academic debates surrounding it. While different targets allow for different things to be "seen" better or worse, these things can be done under any regime given that central banks take in a large amount of data.
- While these distinctions may not be different by much, NGDP targeting has a lot going for it over other options and some distinctions may be more relevant than others. Despite this, some of the issues done under inflation target didn't have to happen even if NGDP makes them "less likely" by being a better lens to see the stance of monetary policy through.
- What really matters is a form of make-up policy to address monetary concerns by making up for past mistakes.
- Also, I just wanted to post something on my blog. :)