Jan Hatzius: The Case for a Nominal GDP Level Target
US Economics Analyst
Issue No: 11/41, 14 OCT 2011 [DOWNLOAD REPORT]
Goldman Sachs Global ECS Research
With short-term interest rates near zero and the economy still weak, we believe that the best way for Fed officials to ease policy significantly further would be to target a nominal GDP path, indicating that they will use additional asset purchases to help bring actual nominal GDP back to trend over time.The case would strengthen further if deflation risks reappeared clearly on the radar screen.
While a shift to a nominal GDP level target would be a big decision, it would be consistent with the Fed's dual employment and price mandate. It differs from the standard Taylor rule interpretation of the dual mandate in two ways. First, it depends on the price level, not the inflation rate. Second, it puts more weight on the output/employment part of the mandate.
Simulations using a highly simplified model suggest that a nominal GDP target could improve economic performance substantially compared with a standard Taylor rule. In the model, the economy receives a significant boost through lower real long-term interest rates, via a delay of the first funds rate hike and temporarily higher expected inflation.
The improvement in economic performance in our model, however, depends critically on the credibility of the Fed's commitment. We believe a nominal GDP level target is less likely to dislodge long-run inflation expectations than other proposals to ease monetary policy significantly further. First, it is not very sensitive to errors in estimating potential output. Second, it is simple, which promotes accountability. Third, there is a natural exit strategy.
Pairing a nominal GDP target with additional asset purchases would enhance the credibility of the shift in the short term. And the shift in the target would raise the likelihood that the asset purchases will be effective—making the whole greater than the sum of the parts.
READ THE FULL REPORT (PDF, 215KB)