What is an Old Lady to Do? Nominal Income or Inflation Targeting

    There are growing calls to consider moving from inflation targets to nominal income targets as the prime objective of monetary policy. There is much merit in such a move. No central bank model yet can accurately forecast the split between real and nominal GDP particularly well as this requires us to understand whether shocks currently driving the economy are primarily demand or supply and also what the slope of short run aggregate supply curve is, which is itself likely to vary with an unknowable level of spare capacity. So the argument runs, let's limit ambition and simply target real GDP growth and, broadly speaking, inflation jointly rather than the latter explicitly and the former implicitly (because inflation is generally thought to be consequence of lagged, current and expected output gaps). Maybe.

    And so this morning, I ran a little simulation of a small macro model with either one of a nominal income targeter and an inflation targeter at the helm. This model is standard with consumption, output, fiscal expenditure, overseas demand, cost-push and a Phillips curve and both a fiscal and monetary policy maker. The Figure below shows us that inflation will rise more and consumption fall less when there is a nominal income targeter in office rather than an inflation targeter in the presence of cost-push shock i.e. ones that depress output and raise inflation. In this simple simulation, the response of agents embeds the policy reaction function and so leads to a higher inflation response because of higher expected output growth when the policy maker is told to care equally about inflation and output compared to being given an inflation target alone. So if you want to see higher nominal growth following cost-push shocks then nominal income targetry may be for you.  On the other hand when we allow the model to be buffeted by a panoply of shocks, such as, autonomous spending, changes in the velocity of money and also fiscal expenditure, the results look quite different: although the variability of household consumption is broadly similar when simulated over the long run, both of nominal interest rates and inflation are significantly more volatile under an nominal income targets. There main reason here, I think, is because fiscal policy is already assigned to the control of output, in these kinds of models, by then also asking monetary policy to consider output, we end up with the two policy arms wrestling somewhat with each other (see Chadha and Nolan, 2003, pp55-57).

Response of consumption, policy rates and inflation to a cost-push shock

    With appropriate assignment, and institutional reform, it may not always follow, of course, that more volatility may be injected by a nominal income target but I am not convinced yet about the need for any change. The main impetus for changes in policy have arisen from the real failures identified during this ongoing financial crisis, which involved an incomplete integration of financial factors in an understanding of what determined macroeconomic stability. And a quick glance at the data do not suggest that nominal GDP growth was especially excessive in the run-up to the financial crisis (see Chadha and Holly, 2011, pp 12 and 29 on this point), though it was perhaps a little stronger than some policymakers would have wanted. But what we probably needed more was a story of why excessive growth in monetary balances, debt and house prices did not show up in the aggregate numbers: what has been called a balance sheet expansion and recession. And so I am not sure that a targeting regime that forced the policymaker to concentrate his or her mind on nominal output rather than inflation would have forced a balanced assessment of (im)balance(d) sheets. Furthermore most of the results I have seen about how to escape a balance sheet recession-cum-liquidity trap seem to involve some form of commitment to inflate, so that the real value of debt is eroded. Moving to nominal income target may well make such signals about the likely future path of inflation hard to impart. Either way, I think the answer is not so much about the form of target but the quality of the analysis about the ongoing developments in the economy and how any emergent problems ought to be stabilised.

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