Exit Easing, Enter NGDP
Let's say you're a policymaker. You worry about a variety of risks. Risks on the upside of your forecast -- like "what if wage growth gets to 3.5 percent?" -- and risks on the downside of your forecast -- like "what if GDP growth slows back down to the 2-percent range, and inflation stays near 1 percent?"
And you have yet more tough problems at the moment. Long-term unemployment is terrible, but it's not clear how much it affects wage determination. (More on that on Monday, by the way.) The risks of overshooting and undershooting full employment are asymmetric -- undershooting is far worse than overshooting -- and what constitutes "full employment" is especially unclear. If you do allow some overshoot, or you realize after the fact you've allowed it, how do you contain expectations of inflation and the monetary-policy response?
These problems, these questions, and this moment all seem particularly suited to nominal GDP level targeting. Why?
1. Because it allows for an overshoot without disordering expectations beyond it.
This is where the "level" part comes in handy. By setting an unambiguous exit path, you circumvent the fear that a temporary overheating in 2015 would be something the Fed has to spend the next few years undoing with tighter policy in 2016, 2017, and 2018.
To the extent to which you can maintain outcomes near an NGDP path, in fact, the degree of temporary overshoot becomes a policy choice. It's determined by the starting level for the NGDP target. My view -- and, for that matter, the apparent view of the Fed's top monetary economist, William English -- is that NGDP level targeting would vastly outperform any alternative policy in terms of closing the output gap quickly without excess inflation, but that trying to return back to the pre-recession NGDP growth path probably implies too much overshoot in the medium run. Check out page 68 of the paper, which graphs a hawkish and a dovish starting point.
2. Because it neutralizes the supply-side issue.
I really don't know how close the U.S. is to its supply constraints. The level of confidence anyone can have has got to be low, though I would assign a higher probably to the "close" view today than I would have before this post. So what you really want is a policy that is robust to that uncertainty -- i.e. that would perform well whether or not supply was an issue.
This is not a particularly good trait of the current policy regime, under which the policy response to changes in inflation after unemployment drops below 6.5 percent has yet to be defined. It is one of NGDP targeting, which abstracts away from the issue of supply by allowing the Fed to just think about the path of nominal demand. The tradition of thinking about NGDP as unaffected by supply goes all the way back to Robert Lucas in 1973.
3. Because NGDP is better than unemployment.
The last few years have shown the unemployment rate to be, at best, a questionable barometer of labor-market conditions and real economic growth. It's not likely those problems -- the shrunken labor force, long-term unemployment, demographic change -- resolve themselves anytime soon. And, if you're not watching unemployment, then what real variable are you watching? It seems to me that one runs out of comprehensive economic summary statistics rather quickly.