Will the UK inflation target be replaced by a target for nominal GDP? This question has gained force from a recent speech by Mark Carney, the next Governor of the Bank of England, in which he said: "Adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than… inflation targeting…When policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting."
If such a move were to happen – and the decision is Mr Osborne's not Mr Carney's - it should be great for share prices if the target works as its advocates hope.
One reason for this is that an NGDP target would imply faster growth than we are likely to get under the inflation target. Most economists think five per cent is a natural target for annual NGDP growth, but the OBR envisages only 4.4 per cent growth per year between 2012-13 and 2017-18. Faster money GDP growth would be good for shares, as it would probably mean stronger growth in profits and dividends.
Perhaps even more importantly, though, a money GDP target would mean less risky share prices. If we all knew that NGDP would rise by five per cent a year on average, a major source of uncertainty about equity prices would disappear.
On both counts, a shift to an NGDP target should raise share prices, in anticipation of both less risk and higher growth.
But equities aren't the only asset that would be affected. An NGDP target would probably mean slightly higher inflation, which would be bad for conventional gilts and good for index-linked ones.
Which brings us to a puzzle. This implies that the possibility of a shift to NGDP targets should have raised share prices and the breakeven inflation rate recently. But it hasn't. I suspect this is because the markets believe that such a shift won't make as much difference as its advocates hope.
One reason for this is that the Bank of England has not been a ferocious inflation targeter. Interest rates have in recent years responded more to the output gap and less to inflation than inflation targeting would predict. And in the last five years, CPI inflation has averaged 3.4 per cent and not the two per cent it is targeted to be. These facts make many economists suspect that the Bank has been a closet NGDP targeter. The MPC "already effectively targets nominal GDP" says Brian Reading at Lombard Street Research.
Also, even if the target of monetary policy does change, the question remains: what weapons does the Bank have to actually hit the target?
Some advocates of NGDP targets think the mere announcement of the targets would help. If people expect money GDP to rise (say) five per cent a year, they’d expect the real value of their cash holdings to be reduced by higher inflation, and they’d expect higher real GDP growth. Such expectations would encourage them to spend and invest more today, thus boosting activity.
I'm sceptical. In the real world the public's expectations are formed more by actual experience than policy announcements. People have consistently expected inflation to exceed its two per cent target. If they don't believe the inflation target, why should they believe an NGDP target?
If expectations are only a weak mechanism, this leaves only one other possibility - that NGDP targeting will bolster the economy simply by permitting more quantitative easing.
This runs into the problem that QE might be losing its oomph. The first doses of it worked in part by reducing tail risk - the small chance of disaster. But now that tail risk has diminished, this mechanism has weakened. And because there's a limit to how low gilt yields can go, there's a constraint on how much the Bank's buying of gilts can boost the economy. And even if this constraint isn't binding yet, there's a risk that high demand for safe assets and a desire to reduce debt will prevent spending rising much in response to lower interest rates. Minutes of the recent MPC meeting show that members thought "it was possible that elevated uncertainty and a desire to reduce leverage meant that real activity was less responsive to lower borrowing costs than normal."
In saying all this, I don't mean that NGDP targeting is a bad idea. It's not at all. My point is that it just might not be as great as its advocates hope. And judging by the markets' lack of excitement about the possibility of such a policy shift, they seem to share my scepticism.
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Chris blogs at http://stumblingandmumbling.typepad.com