Carney Should Embrace NGDP
(Originally published here.)
Mark Carney's arrival as the new head of the Bank of England on July 1 is an opportunity for the U.K. to rethink monetary policy. As a Canadian, Carney is an outsider, and he'll have a clean slate because the central bank’s two current deputy governors are leaving as well. I'm hoping the U.K. seizes the moment and embraces an idea that Carney has flirted with in recent speeches -- adopt an explicit target for nominal gross domestic product.
The Bank of England works under a mandate set by the government but has operational independence in meeting it. The appointment of a new governor is a good time for a change of mandate, and that's what's required. When Mervyn King became governor in June 2003, the Treasury redefined the bank’s goal as an inflation rate of 2 percent, as measured by the Consumer Price Index. (The bank's target had previously been inflation of 2.5 percent, measured by a different inflation index.) George Osborne, the U.K.'s chancellor of the exchequer, should revise Carney's instructions more radically.
The case for replacing the inflation target with an NGDP target is by now familiar. For a fuller explanation, see this note, but here's the short version. Prices are a poor measure of the macroeconomic fluctuations that central banks exist to moderate. The best measure is aggregate demand -- another name for NGDP.
Officially, the Bank of England has been targeting inflation since 1992. In practice, it has often shown a flexibility reminiscent of NGDP targeting -- sometimes accepting higher inflation when economic growth slowed and pushing it lower when growth quickened. In 2008, though, aggregate demand collapsed, and the bank let it happen. NGDP fell some 10 percent below trend. That was a mistake. The inflation target, even flexibly interpreted, was sending the wrong message.
It's true that Carney has seemed to blow hot and cold on NGDP, but this isn't necessarily a bad thing. It shows he's open-minded on the subject -- and willing to discuss it in public, a rare trait among top central bankers. Carney’s endorsement would carry the weight of a deeply considered judgment and give Osborne a firm push.
In a speech last year, Carney called an NGDP target “more powerful” and “more favorable” than an inflation target when the central bank’s interest rate is at zero. In testimony this February, though, he raised concerns. Suppose potential real growth rises for some reason and stays higher. Then the NGDP target implies that inflation must fall by the same amount, and stay lower. “As potential real growth changes over time," he told a parliamentary committee, "either the nominal target will have to change or else it will force an arbitrary change in inflation in the opposite direction."
Identifying changes in potential growth isn't straightforward, least of all at a time like this. So Carney's probably right that now and then inflation would be forced to run above or below the desired rate until the Treasury revised its mandate and set a new NGDP target. This seems a small price to pay for the other benefits.
If Osborne and Prime Minister David Cameron can be persuaded to go along, Carney would be the right man in the right place at the right time.