Evan Soltas
Apr 11, 2012

With Interest

Does NGDP targeting require interest rate volatility?

So I've been doing some serious thinking and research over the last few days into the variant-target monetary policies I wrote about in mid-March (see here, here, and here if you're a new reader of the blog).

I'd been interested, most critically, in what economists call the "loss function" of the central bank, with variance in real output growth and inflation from their trend rates representing relevant losses. One could look at the empirical data, I reasoned, and determine how the central bank assigned relative weights to inflation and real-output deviations.

My understanding has changed a little bit as I've gone forward, namely I've recognized that interest rate variability, since it would compromise the efficiency of investment allocation and capital markets, has costs, although I think it's pretty clear that it should be substantially lower weighted than, say, inflation or real output deviations.

I'll post more about my research (and hopefully get some suggestions and feedback) tomorrow, but I'll pose to you one of the questions with which I've been wrestling: if the central bank pursues NGDP level targeting, using futures markets and expectations, would you expect that to lead to more or less interest rate volatility?

There is, of course, a rather clear argument that it will lead to more. Since it entirely ignores the policy instrument -- unlike a Taylor rule, importantly, in this respect -- an NGDP target may send instrument measures all over the place as it aims to hit a target. One might argue that we saw this happen from 1978 through the early 1980s, when the Humphrey-Hawkins Act required the Fed to hit money supply growth targets.

Then I considered the counter-argument. An NGDP target better manages expectations for nominal growth, which should stabilize interest rates and prevent the need for sudden rate cuts due to nominal shocks. That would imply that an NGDP target would outperform discretionary policies and flexible inflation targets which assign lesser weights to real output.

And indeed, I found that it is the latter thesis which is supported by the data. Above, I've graphed the short-term interest rates in the United States, the United Kingdom, Australia, and Canada. I consider Australia an NGDP targeter this entire time span.  Also, I think it's fair to say that the UK maintained a de facto NGDP target up until 2008, at which point it assigned a substantially higher weight to inflation -- I've shown this in the past. Canada is more of a flexible inflation targeter, and the US is purely discretionary, but with the strongest weight on inflation.

The order I've just listed the countries -- Australia, the UK, Canada, and last the US -- is also the order, not coincidentally, from least to most interest rate volatility. It's clear that because NGDP targeting does a better job managing aggregate demand, that the outcomes for interest rate stability are far superior to the results of flexible inflation targeting or discretionary policies.

Oh, just a small note: the Australia data series is actually the RBA's discount rate, since FRED seems to be missing large chunks of the time series, but I looked at both data sets, and the discount rate seems to be a close-enough proxy.