The past several years have assaulted the core of what central bankers once took for granted about their role. A comprehensive review is required. At the top of the list is a sensitive subject that many in the fraternity would rather avoid: How should central banks be told to balance the goals of low inflation and low unemployment?
Before the Great Recession, this question had mostly been set aside. Economists decided that the goals of price stability and high employment weren’t really in conflict. In 1969, Milton Friedman and Edmund Phelps showed that there’s no long-run trade-off between inflation and output. That is, tolerating higher inflation doesn’t buy you faster economic growth. Believers in the new theory of “rational expectations” took this further and said there was no short-run trade-off either.
What a convenient finding that was for central banks. It meant they could be told to keep prices stable and left alone to get on with it. Independent central banks would be better at keeping inflation low than banks under the political control of finance ministries, ever tempted to print money to pay for their programs. And if low inflation didn’t hurt growth, why not set them free?
Right now, inflation is very low—so low that deflation is a real concern. Falling prices disrupt an economy (especially one burdened with debt) far more dangerously than rising prices. Also, the recent recession has shown that keeping inflation low is not enough. The short-term trade-off between low inflation and low unemployment is real—and in a recovery with protracted deleveraging, like this one, the short term isn’t as short as Friedman and Phelps thought.
We suggest looking at an old idea that’s again attracting attention among monetary economists. Recast the target that the U.S. Federal Reserve and other central banks are told to follow. Instead of a target for low inflation, plus an additional primary or secondary target of high employment, adopt a target for the money value of output, or nominal gross domestic product. This combines prices and output in a single number.
Suppose the target was 5 percent. Over the longer term, with the economy growing at 2 percent or a little more, inflation would be 3 percent or a little less, similar to the inflation targets most central banks (including the Fed) have adopted. And here’s the advantage: In the short term, the Fed would be on target if the economy was growing at 5 percent and inflation was zero, or if the growth was zero and inflation was 5 percent.
The bank would still have to decide how quickly to bring demand back to target if it overshot or undershot, and this could be politically contentious. Yet it would help, because the bank’s actions would be easier to understand and explain. There are other doubts and unresolved questions with the use of nominal GDP targeting, but the idea surely merits serious consideration.