Monetary stability is what matters Mr. Carney

Quite a lot is being said and written recently on nominal income targeting. Mr. Carney, the new elected governor of the Bank of England, has had a primary role in it. Even though there has been a debate amongst academics and central banks’ analysts for quite a long time, his recent suggestion in a public speech (see here) of a nominal income rule for the conduction of monetary policy by the Bank of England has been the true milestone that have triggered the debate on monetary policy strategies across the world, and particularly in the UK. Almost everyday many commentators and columnists are analysing this question in prestigious and influential business papers such as Financial Times or The Economist. This is not surprising at all, as nominal income targeting is presented as an alternative to inflation targeting, the monetary strategy framework used de facto or officially by most central banks during the last business cycle expansion, the years of the so-called Great Moderation.

This debate is needed and essential for the conduction of a more stable monetary policy in the near future, but we should analyse in more detail what is being exactly proposed and for which purposes.

Just a transitory solution?

First of all, it is important to remember that Mr. Carney suggested the adoption of a nominal income rule as a new (and more flexible) policy framework to provide even further monetary stimulus to the economy. And, in particular, he has suggested a nominal GDP level target. However, following his own words, it can be interpreted as just a transitory policy proposal to allow the central banks the injection of more money in the economy. This is confirmed by the tone of the comments/articles published on his proposal, which evidenced a warm welcome by all and sundry. Just see below the reaction of The Economist  (“Shake´em up Mr Carney”) last week as an example, even suggesting a nominal GDP rate of growth target to be adopted by the Bank of England:

“That is where the nominal GDP target comes in. By promising to keep monetary conditions loose until nominal GDP has risen by 10%, the Bank would provide certainty that interest rates will stay low even as the economy recovers. That will encourage investment and spending. At the same time an explicit target of 10% would set a limit to the looseness, preventing people’s expectations for inflation becoming permanently unhinged. It is an approach similar in spirit to the Federal Reserve’s recent commitment not to raise interest rates until America’s unemployment rate falls below 6.5%”.

Following this article, there is no doubt that this strategy is taken as a mere temporary solution, just for the current (very much extraordinary) time:

“The last problem is Mr Osborne. A temporary nominal-GDP target needs his explicit support. He should give it, because against a background of tight fiscal policy, monetary policy is the best macroeconomic lever that Britain has”.

So are we just discussing about a temporary solution for an extraordinary scenario or are we proposing a permanent change of the monetary strategy followed by the Bank of England since 1998? The test to evaluate the true commitment of central banks to a more reliable and stable monetary policy rule will come when the economy enters into a new expansionary phase in the near future. At that time, a nominal income rule committed to monetary stability will prevent money and credit from growing as much as they both did in the past; so it will become much harder to follow it. We will see then how committed central bankers, academics and market analysts are to the conduct of this monetary rule.

Not a single but many nominal income rules

Secondly, there is no a single nominal income rule. Many considerations matter in its operational definition: it could be adopted either in terms of nominal GDP levels or in rates of growth; if just current indicators or alternatively expected variables enter into the decision-making process, it could be either a backward or a forward-looking rule; depending on the ability given to the central bank to react to (registered or expected) deviations from the target, it could be a passive (or non-reactive) or an active rule; the selection of the inflation and GDP growth targets obviously matter a lot, … . So, as some of their critics suggest, I agree that they could be used by central banks to inflate the markets in an attempt to manage again aggregate demand and real variables (see some on the critics here; made by a true expert in monetary economics, professor Goodhart). However, I do not agree with the critics on their entire dismissal of these rules, as they do not  have to be necessarily inflationary and destabilising monetary rules at all; quite the contrary!

You can find more detailed explanations on nominal income targeting and the reply to its most common critics in two excellent blogs on monetary economics: Scott Sumner´s The money illusion and Lars Christensen´s The market monetarist. I wrote a brief article on these rules in 2005 for the Journal of the Institute of Economic Affairs: “Towards a more neutral monetary policy: proposal of a nominal income rule”. As you will see there, I proposed a nominal income rule committed to maintaining monetary stability and not price stability; one by which (broad) money supply grows at the expected  rate of growth of the economy in the long term, and at the same time allowing prices to fall. As evidenced in a more recent paper written with professor G. Wood (see the full version here), its application would have led to much lower rates of growth of money during the last expansion of the economy and, on the other hand, it can be said that it would have avoided the sudden collapse in money growth since 2008. In sum, it would have provided both a (1) less inflationary and (2) more stable rate of growth of money.

Leaving the details (some very important indeed) aside, I do support a permanent change in the monetary policy strategy of central banks. It is time to abandon inflation stabilising rules that, as it is evident for almost all now, have not led to monetary nor financial stability.

A solid theoretical background: monetary stability rather than price stability

There has been a long debate and controversy amongst the supporters and critics of price stabilisation as a criterion for the running of monetary policy (2). F. A. Hayek masterly stated in the 20s and 30s how inflationary the application of that policy criterion could be in the presence of growing economies. As he explained, those central banks committed to maintaining price stability have to inject more money into the markets just to offset the (benign) deflationary pressures accompanying the expansion of the economy; which leads to a rapid (and unsustainable) growth of money and credit that finally distorts financial and real markets (the so-called “boom and bust” business cycle theory). However, since the end of WWII, and after three decades of fine tuning monetary policies and central banks subject to the financial needs of a growing State, the proposal and adoption of (low though positive) inflation targets since the late 70s was received as a blessing by mostly all; especially by the academia, who had been claiming long ago for a more consistent policy rule committed to price stability in the medium to the long run.

The american economist George Selgin followed Hayek´s lead and proposed in his excellent 1997´s “Less than zero. The case for a falling price level in a growing economy” (entirely available at the IEA´s site) what he called a “productivity norm”; which, in a nutshell, allowed for some (mild and benign) deflation when productivity and the supply of real goods and services are growing.

A discussion on monetary policy rules is essential to avoid some of the (monetary) mistakes made during the last expansion of the business cycle. We have already seen how the adoption of price stability as a policy target, or worse (CPI) inflation targeting rules, do not necessarily contribute to financial stability in the medium to the long run. J. A. Aguirre and I have proposed recently (see more details on our book here) another policy rule; one committed to monetary stability that prescribes money growth in line with the real growth of the economy in the long run, and allows for disinflation and even mild deflation when productivity growth increases the output of goods and services in the economy. Nominal income targeting may well be a (only one of them) way to implement it.

We have been waiting for a debate on this question for quite a long time and is indeed very much welcome.

Juan Castañeda

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(1) However, both in the oral and written evidence provided to the UK Parliament´s Treasury select committee this week Mr. Carney was much more conservative, and in fact supported the current “flexible inflation targeting” strategy of the Bank of England.

(2) As to the critique on price stabilisation rules, see some of my previous entries to the blog:

– “Central banks price stabilisation rules creates inflation”

– An a paper I wrote with Pedro Schwartz on this question: “Price stability does not always lead to monetary stability nor to financial stability” 

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Is nominal income targeting really on the table Mr Carney?

In a recent speech at Toronto, the next Governor of the Bank of England, Mr. Carney, has recently suggested (or better, implied) that nominal income targeting could be a better alternative monetary strategy to flexible inflation targeting. This is not trivial at all, and has not received enough attention in the media yet (amongst those who did, see Lars Christensen´s entry to his very interesting blog: “The Market Monetarist” from which I knew about it).

Mr Carney may have wisely identified one of the main flaws of  past monetary policy decisions and a major cause of the financial distress suffered in most developed economies since 2007/08: by targeting inflation and, even worse, CPI inflation, most central banks achieved price stability yes (thus defined), but at the same time credit and liquidity expanded too much and for too long worldwide. During the years of the expansion of world output prior to 2007 (during the so-called “Great Moderation” years), mainly due to significant technological progress and the huge development and growth of India and China´s exports of manufactured goods in international markets, a growing world supply of consumption goods and services led to quite stable and moderate (consumption) prices. However, at the same time (in particular, since early 2000s years), any measure of broad money growth showed an exceptional increase in liquidity, which distorted agents´s investment decisions and resources allocation. We now know how it badly ended in huge financial instability, massive output losses and employment cuts and even economic depression in some peripheral EMU countries. In a nutshell, as leading economists of the 20s clearly identified and stated (F.A. Hayek amongst them, or George Selgin in our days), in a growing economy, the conduct of a price stability rule does not guarantee monetary stability, nor financial stability. Contrary to what is commonly thought, it is not a necessary condition I am afraid (see more details here).

Unlike the standard “inflation targeting” strategy, the one adopted by the Bank of England (and many others) since 1998, a nominal income rule does not set an inflation target alone but a nominal income target. By doing so, the central bank would adopt the joint evolution of prices and real output as the policy target. Under this rule, if the economy is growing, an increasing supply of real output may be offset by decreasing inflation or even mild (benign) deflation, thus leading to a more modest nominal income measure, and thus less money growth. In my view, if adopted as a policy rule, this alternative monetary policy would have resulted in more modest and stable money growth (thus more money stability) and it may have reduced the likelihood of the massive dislocation of financial markets occurred in recent years. The theoretical basis of this rule can be seen in the work I published in 2005 for the Journal of the Institute of Economic Affairs, as well as its application in a more recent academic work I wrote with professor G. Wood. As stated in both works, a nominal income targeting rule is more compatible with monetary stability, a true necessary condition to achieve long run economic growth as well as financial stability.

There is a now a much clearer support for this type of rules. The reason is quite obvious: as real GDP is stagnated if not decreasing and CPI inflation is still moderate (roughly around 2%-3%), the conduction of a nominal income rule which targets the rate of growth of real GDP in the medium to the long run would produce higher rates of growth of money, being thus even more expansionary. This might be the reason why it is becoming a quite popular rule in our days. However, this is not all. In order to be a stabilising (sound and beneficial) rule in the medium to the long run, it should be fully symmetrical; so that in a context of a new phase of economic growth and disinflation (or mild deflation) liquidity growth becomes much more moderate than in the years prior to 2007. This will be the true test to this rule, if ever applied by central banks in the coming years.

Let´s see in the coming months if a very much needed debate on monetary policy rules is finally open in the UK or elsewhere. At least a major figure amongst central bankers has suggested it. Well done and good luck Mr Carney!

Juan Castañeda

PS. I want to acknowledge and thank Lars Christensen for his excellent blog on monetary economics (The Market Monetarist), from which I learned about Mr Carney´s speech.

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