Fed Considering Changing Its Strategy to Target NGDP

By Joseph Lawler 

According to the Financial Times, the Federal Reserve is considering, among other things, changing its strategy from focusing on an implicit inflation target to targeting a nominal gross domestic product (NGDP) level.
In other words, instead of doing one-off programs like QE2 and Operation Twist to try to steer things in the direction of 2 percent inflation, the Fed announce that it would manipulate its balance sheet in whatever way it needed to to put the country on a path to hit a certain level of current spending.
What makes it so remarkable that the Fed is even considering this change is that the idea more or less originated in the blogosphere, thanks to the work of one blogging economist, Scott Sumner of Bentley College, who maintains The Money Illusion. The Wall Street Journal's Kelly Evans has a good backgrounder on NGDP targeting, including great links.
The best explainer of the pros and cons of NGDP targeting, however, was written by Sumner himself, and appeared in the fall issue of the great National Affairs.

 

Why NGDI targeting is superior to NGDP targeting

TheMoneyIllusion

Tyler Cowen linked to an interesting article in the FT, explaining why Gross Domestic Income is much more accurate than Gross Domestic Product:

Since the start of the recession, GDI has proved the more accurate depiction of US economic performance, according to [Jeremy] Nalewaik’s work. As better data have become available and the Bureau of Economic Analysis (which calculates both) has accordingly revised its earlier estimates, it is GDP that has been adjusted in the direction of GDI rather than the other way round.
Have a look at this chart from Nalewaik’s recent paper:

Neither measure was perfect, but early GDI estimates were much closer than GDP to later revisions of both measures. Perhaps more tellingly, GDI started signaling an economic slowdown in the middle of 2007 even as GDP kept climbing. Early GDI estimates also turned out to better reflect the severity of the recession.
To give the most glaring example, the initial GDP estimate for the fourth quarter of 2008 showed that the economy contracted by 3.8 per cent. It was released on January 30, 2009 — about three weeks before Obama’s first stimulus bill passed. That number was continually adjusted down in later revisions, and in July of this year the BEA revised it all the way down to a contraction of 8.9 per cent.

The FT is discussing real GDP and real GDI, but I believe the same applies to the nominal versions.
Some commenters have pointed to a flaw in NGDP targeting, level targeting.  If there is a sudden and massive revision in the current level of NGDP, it would force the Fed to shoot for much more or less than 5% NGDP growth over the following year.  That could be destabilizing.  Generally the revisions to current NGDP aren’t that large, but on occasion they can be significant.  Thus I now think NGDI is the better target.
The article also sheds light on the ultra low RGDP growth in early 2011, which many took as evidence that QE2 failed.  But at the time it seemed like QE2 was working, as the monthly jobs figures increased substantially, and other data such as ISM numbers showed an extremely strong economy.  So how could the RGDP numbers have been so weak?

Speaking broadly, two types of evidence suggest that the initial estimates of GDI are typically better than the initial estimates of GDP.
First, a variety of business cycle indicators that should be highly correlated with output growth–including the Institute for Supply Management surveys, the change in unemployment, some financial market variables, and even GDP growth forecasts themselves–have actually been more highly correlated with GDI growth than with GDP growth in recent decades.
That last item on the list is worth emphasizing: economists forecasting GDP growth have produced median forecasts that have tended to be more highly correlated with GDI growth than the variable they are trying to forecast.  It is also notable that GDI growth tends to predict GDP growth next quarter better than GDP growth itself.  All this suggests initial GDI growth is picking up some real fluctuations in the economy that are being missed by the initial GDP growth estimates.
Second, initial GDI growth estimates have tended to predict revisions (typically years later) to initial GDP growth estimates, especially since the mid-1990s.  So, if initial GDI growth is above initial GDP growth, GDP growth tends to revise up, and if initial GDI growth is below initial GDP growth, GDP growth tends to revise down.
For an example of the latter, just look to the recent recession.  In March 2009, the Bureau of Economic Analysis announced that real GDP declined 0.8 percent from the fourth quarter of 2007 to the fourth quarter of 2008, while their GDI calculations showed a much more substantial decline of 2.1 percent.  The latest Bureau of Economic Analysis estimates show declines over that time period of about 3 percent, using either measure.
So, while neither measure initially captured the full severity of the downturn in 2008, the picture painted by the initial GDI estimates was quite a bit closer to the revised figures (which incorporate more complete data and are generally assumed to be more accurate).
What is GDI telling us about the economy now vs what GDP is telling us?
GDI paints a less-bleak picture of the economy recently.  In the first quarter this year, the latest real GDP growth estimates show annualized growth of 0.4 percent, while the latest real GDI growth estimates show 2.4 percent growth.  Other economic indicators like the Institute for Supply Management surveys and the change in the unemployment rate were looking quite healthy over the first few months of this year, suggesting GDI was more accurate in the first quarter.  In the second quarter this year, GDP growth is currently estimated at 1.0 percent while GDI growth is 1.5 percent, so GDI again looks better, but the difference is less sharp.

So the real GDP estimate for the first quarter of 2011 was probably wrong.  To be sure the RGDI number is also disappointing, but at least it isn’t horrible.  Unfortunately it will be many years before we know what actually happened, but for now I’m sticking with ISM numbers and jobs numbers as the best near-term indicators.
Even by those criteria, QE2 was far less than needed, but I’d add that ever since the Fed signaled (in the spring) that it wasn’t going to extend QE2 after June, the economy has done even more poorly than during late 2010 and early 2011.  QE2 was far too little to make a major dent in the economy, but it was probably still better than nothing, which is all we have today.
Now for the joke.  Some readers might have assumed that I am abandoning my advocacy of NGDP targeting.  No so, because NGDP and NGDI are exactly the same thing.  Thus I still favor NGDP targeting.  However government estimates of NGDP and government estimates of NGDI do differ.  And it seems like reported NGDI is the more accurate estimate of actual NGDP/NGDI.  Thus the actual implementation of NGDP targeting should involve the targeting of futures contracts with a value at maturity linked to future announcements of NGDI.