Central banks still seek transparent and credible communication. But signalling intentions, through forward guidance or some degree of commitment to an intermediate target, poses a difficult tradeoff. The advantages of transparency and credibility versus the disadvantages of waking up one day to find that unexpected developments have turned past statements into unwanted constraints on current monetary policy.
Many candidates for intermediate target have been tried and many have failed. During the heyday of monetarism in the early 1980s, many central banks announced targets for the rate of growth of the money supply. Those targets had to be abandoned when velocity shifts -- more specifically, unexpected increases in the demand for money -- rendered them impossibly restrictive. Many emerging markets went back to targeting the exchange rate, only to be forced by balance-of-payments shocks in the late 1990s to abandon this nominal anchor as well.
Next up was inflation targeting. The new kid on the block quickly became popular with both developed and developing countries. But many of them have been missing their inflation targets – especially the developing countries (Fraga et al. 2003). When the world price of oil rises unexpectedly, for example, inflation-targeting oil-importing countries are forced to choose between disavowal of their inflation targets on the one hand, and a currency-appreciating monetary contraction strong enough to prevent domestic oil prices from rising, on the other hand. The first choice defeats the purpose of having a target (transparency and communication) while the latter choice means perversely responding to an adverse terms of trade shock by appreciating the currency. Inflation targeting particularly lost luster in the Global Financial Crisis of 2008 (Reichlin and Baldwin 2103), analogously perhaps to the disenchantment with exchange rate targets in the currency crashes of the 1990s and with monetary targets in the early 1980s.
When a central bank repeatedly misses its proclaimed guidance or targets, it ends up with less credibility than if it had not said anything in the first place.
Perhaps the monetary authorities in advanced countries will give up for a while on trying to express their intentions simply in terms of a single economic variable. But central banks in emerging markets and developing countries may not have this luxury. They tend to have a more acute need to earn credibility than those in advanced countries, due sometimes to a past history of high inflation, an absence of respected institutions, or political pressure to monetise budget deficits.
Proponents of Nominal GDP targeting have suggested a solution. If the monetary authorities express their annual intentions in terms of Nominal GDP (NGDP), then they are likely to be able to live comfortably with what they have said, regardless of future developments. In particular, in the event of an adverse supply shock or shift in the terms of trade, a NGDP rule says to hold aggregate demand steady, which is pretty much all that monetary policy can be expected to do. The supply shock is absorbed equally in the forms of inflation and lost output. This is probably close to how most policymakers would choose to react anyway, even if unconstrained by their own past statements. An inflation rule, by contrast, calls for responding with tighter monetary policy and a more severe recession (e.g. Frankel, 1995, or Frankel et al. 2008.)
Targeting Nominal GDP has been proposed in the context of major industrialised countries. (Frankel, 2012, gives other references to the literature.) But a good case can be made that the idea is in fact more applicable to countries further down the income ladder. The reason is that emerging market and developing countries tend to experience bigger terms of trade shocks and supply shocks than industrialised countries do. NGDP targets are robust with respect to precisely these kinds of shocks.
The recent revival of NGDP targeting has focused on the case of countries that seek to achieve a credible monetary expansion, including usually an increase in expected inflation (Woodford 2012). The motive has been to address economic weakness in the US, UK, Eurozone, and Japan, in the aftermath of the severe negative demand shock that hit them in 2008. Most developing countries do not particularly need monetary expansion or higher inflation at present. But NGDP targeting, viewed in a wider perspective, is a way to achieve any monetary setting, not just expansion. When it was originally proposed by Meade (1978) and Tobin (1980) and supported by many other economists in the 1980s, the motive was to achieve credible monetary discipline, particularly a decrease in the inflation rate, rather than credible monetary expansion and an increase in inflation. Disinflation is still needed in some developing countries, such as India, Indonesia, South Africa, and Turkey. Regardless, the attractive feature of NGDP targeting, its robustness to unknown future shocks, is similar whether applied at times when the medium-term objective is a monetary setting that is easier, tighter, or unchanged.
Emerging markets and developing countries tend to be more exposed to trade shocks because they are more likely to be price takers on world markets and, in many cases, to export agricultural and mining commodities. They tend to be more exposed to supply shocks because of physical exposure to natural disasters such as earthquakes and windstorms, social instability such as strikes, the importance of agriculture in their economies, and productivity changes. Productivity shocks are likely to be larger in developing countries. During a boom, the country does not know in real time whether rapid growth is a permanent increase in productivity growth (it is “the next Asian tiger”) or temporary (the result of a transitory fluctuation in commodity markets or domestic demand). The trend growth rate in emerging market countries is highly uncertain (Aguiar and Gopinath 2007).
Weather fluctuations, natural disasters and terms-of-trade shocks are particularly useful from an econometric viewpoint, because these supply shocks are both exogenous and measureable, and so can be used to estimate a two-equation supply-and-demand system. Exogenous productivity shocks – the staple of theoretical models -- are much harder to pin down empirically.
The argument can be illustrated in a model where the ultimate objective is minimising a quadratic loss function in output and inflation but a credible rule is needed in order to prevent an inflationary bias that arises under discretion, as in Rogoff (1985). It turns out that a NGDP rule dominates inflation targeting unless the aggregate supply curve is especially steep or the weight placed on price stability is especially high. Under certain assumptions, the necessary condition for a NGDP rule to dominate is simply that the slope of the supply curve is less than 1+√2 (Frankel 2014).
In recent research we have tried to see whether this criterion is likely to hold, by estimating the parameters of aggregate demand and aggregate supply curves in some middle-sized middle-income countries where exogenous supply and trade shocks are thought to be especially large, exogenous, and measurable. World oil prices are an exogenous source of terms of trade fluctuations for oil exporters like Kazakhstan as well as oil importers like India. Monsoon rains are another important exogenous supply factor for India. Exogenous demand factors include trading partner income and some particular categories of domestic government spending. Parameters estimated for the cases of India and Kazakhstan suggest that the aggregate supply curve is flat enough to satisfy the condition necessary for NGDP targets to minimise the quadratic loss function, relative to inflation targets. (Bhandari and Frankel, 2014, for India, 1996-2013; and Frankel, 2013, for Kazakhstan, 1993-2012.) Intuitively, if an inflation targeter responded to an adverse supply shock by preventing the price level from rising, the necessary fall in output would be undesirably large.
The statistical estimates warrant a truckload of qualifications. But other researchers have also estimated short-run supply slopes in this range. The theory leaves a lot out as well. But the basic point is that central bank pronouncements phrased in terms of nominal GDP are less likely subsequently to run afoul of the supply and trade shocks so common in developing countries, compared to pronouncements phrased in terms of inflation. This basic logic holds regardless whether the goal is disinflation or reflation; whether we are thinking in levels or rates of change; and whether targets are to be expressed in terms of ex ante forecasts or ex post target ranges. If it is worth communicating a plan, it is worth choosing a plan that one can live with.
References
Aguiar, Mark, and Gita Gopinath (2007), "Emerging Market Business Cycles: The Cycle Is the Trend", Journal of Political Economy, 115, pp 69-102.
Bhandari, Pranjul, and Jeffrey Frankel (2014), “The Best of Rules and Discretion: A Case for Nominal GDP Targeting in India”, CID WP No. 284, Center for International Development, Harvard University, July.
Fraga, Arminio, Ilan Goldfajn and André Minella (2003), “Inflation Targeting in Emerging Market Economies”, Ken Rogoff and Mark Gertler, eds., NBER Macro Annual 2003 (Cambridge, MA: MIT Press).
Frankel, Jeffrey (1995), "The Stabilizing Properties of a Nominal GNP Rule", Journal of Money, Credit and Banking, 27, no.2, May.
--- (2011), “Monetary Policy in Emerging Markets: A Survey”, published in Handbook of Monetary Economics, edited by Benjamin Friedman and Michael Woodford (Elsevier: Amsterdam).
--- (2012), “Central Banks Can Phase in Nominal GDP Targets Without Damaging the Inflation Anchor”, VoxEU.org, December.
--- (2013), "Exchange Rate and Monetary Policy for Kazakhstan in Light of Resource Exports", Harvard Kennedy School, December.
--- (2014), “Nominal GDP Targeting for Middle-Income Countries”, forthcoming, Central Bank Review, vol. 14, no.3, September (Central Bank of the Republic of Turkey). HKS RWP 14-033, July.
Frankel, Jeffrey, Ben Smit and Federico Sturzenegger (2008), "Fiscal and Monetary Policy in a Commodity Based Economy”, Economics of Transition 16, issue 4, Oct. pp. 679-713.
Meade, James (1978), “The Meaning of Internal Balance”, The Economic Journal, 88, 423-435.
Reichlin, Lucrezia and Richard Baldwin (2013), Is inflation targeting dead? Central banking after the Crisis, VoxEU.org, 14 April.
Rogoff, Kenneth (1985), “The Optimal Degree of Commitment to an Intermediate Monetary Target”, Quarterly Journal of Economics, 1169-1189, November.
Tobin, James (1980), “Stabilization Policy Ten Years After”, Brookings Papers on Economic Activity 1: 19-72.
Woodford, Michael (2012), “Methods of Policy Accommodation at the Interest-Rate Lower Bound”, Jackson Hole symposium, August (Federal Reserve Bank of Kansas City).
