Evan Soltas
Jul 14, 2012

How to Get the Fed to Target NGDP

Scott Sumner has long said that instead of trying to directly convince the Fed to switch to an NGDP target, what the supporters of such a target must do is convince a majority of economists of the proposition, and the Fed will soon follow.

I don't disagree with Sumner -- but I think that, looking at the history of inflation targeting, there might be a prerequisite step. What is first needed is to convince at least a handful of countries to initiate an explicit NGDP target.

New Zealand's central bank adopted its inflation target range between 0 and 2 percent in 1988. Then came Chile's central bank in 1990 with a 3 percent annual inflation target, with a range of plus or minus 1 percentage point. In 1991, Canada, Israel, and Colombia joined in. The United Kingdom signed on in 1992, as did Australia and Sweden in 1993.

With the winds of inflation targeting blowing at full gale, when did the Fed formally debate the policy and resolve that a long-term implicit inflation target of 2 percent in core CPI would be the way they went? 1994.

(See here for an excellent discussion of the FOMC's policy debates from 1993 to 2002 -- section six is on inflation targeting -- written by one of the main advocates for inflation targeting at the Fed, Marvin Goodfriend, who further discusses the later-realized possibility of an explicit inflation target here.)

Academic consensus is critical. But nothing is more convincing than success. Daniel Thornton, an economist at the St. Louis Fed, wrote in a short history of inflation targeting that:

[P]olicymakers’ belief in the efficacy of monetary policy for inflation control changed dramatically in spite of the fact that there was no fundamental refutation of what I call the monetary policy ineffectiveness proposition (MPIP). The evolution to inflation targeting occurred because central banks, most importantly the Federal Reserve, demonstrated that monetary policy could control inflation. It was not a consequence of fundamental advancements in the profession’s understanding of how monetary policy affects the economy.
The lesson learned from the inflation-targeting debates is that NGDP targeting needs to be given a test run, and that market monetarists' advocacy is best applied not at this moment towards American economists, but towards economists at foreign central banks.

The next question is to ask which central banks can be most easily swayed. Here are a few selection criteria which I find obvious: (1) the country should be small, (2) the country's central bankers should be academics, (3) the country should have a history of leading the monetary policy consensus, instead lagging like the Fed.

My conclusion is that the list of such countries for NGDP is almost identical to the inflation-targeting list. The Reserve Bank of Australia, which targets inflation of 2 to 3 percent "over the cycle," would be my first candidate, given the similarity of their target as written and in its application to an NGDP target. I've written about the Bank of Israel before as a de facto NGDP targeter; if a campaign for NGDP targeting is to begin in earnest not only in academia but in central banks, pushing Israel to pioneer the policy makes a great deal of sense. Sweden also seems like a natural pick. With that base of support, the first big-country central bank to pressure would probably be the Bank of England, given their history of sympathy with NGDP targeting.

And by that point, the Fed will be well on its way towards action.

Note: Noah Smith observes on Twitter that NGDP targeting will work differently in small, open economies. This is a good point which needs to be further developed. And it (probably) means that we need Australia or another diversified mid-size economy to give it a go.