“The actual instrument adjustments necessary to make a nominal GNP rule operational are not usually specified in the various proposals for nominal GNP targeting. This lack of specification makes the policies difficult to evaluate because the instrument adjustments affect the dynamics and thereby the influence of a nominal GNP rule on business-cycle fluctuations.”

John Taylor, “What Would Nominal GNP Targeting Do to the Business Cycle?”, 1985

The above quote is from a Taylor paper from 1985 in which he assessed the possibility of the Federal Reserve adopting a nominal GDP target. He has many positive things to say, but also makes the above criticism. He reiterates the same criticism more recently in a blog post, and he also made the same point when, last November at the Milton Friedman centennial celebration, I asked for his opinion on the recent surge in interest in NGDP targeting. Stephen Williamson makes a similar point at his blog.

Taylor’s criticism is that NGDP targeting is formulated as a rule for a policy goal, rather than a rule for a policy instrument, and that this not optimal. To clarify this, let’s do some quick definitions:

Goal variable: The ultimate variable which a central bank seeks to influence.
Examples: inflation, unemployment, NGDP, price of gold

Policy instrument (AKA operating instrument, or just instrument): A variable which the central bank directly controls and uses to manipulate the goal variable.
Examples: monetary base, expectations about the future level of the monetary base, reserve requirements, the interest rate on reserves, the discount rate

Intermediate target: a variable that stands between the instrument and the goal variable
Examples: monetary aggregates (M1, M2, etc.), federal funds rate

To put it all together in a concrete example, the Fed’s current goal variable is inflation, which influences using the intermediate target of the fed funds rate, which in turn is directed by several policy instruments (the Fed’s control of the monetary base, the level of bank reserves, the interest rate on reserves, the discount rate, and expectations about future levels of all of the preceding).

Taylor criticizes NGDP targeting advocates as proposing a change in the goal variable, but not prescribing a rule for policy instruments to achieve that goal. He says NGDP targeting proponents having a destination without a plan for getting there.

However, if NGDP targeting is flawed for not being prescribed as a rule for an instrument, then Taylor’s preferred monetary policy – the eponymous Taylor rule – is equally flawed.

The Taylor rule is an equation which would be used to determine the level of the fed funds rate which the Fed should target. The fed funds rate, however, is not something the Fed directly controls and thus is not an instrument of the Fed. It is an intermediate target, as stated above.

Why is the fed funds rate an intermediate target? When the FOMC meets and declares that it is raising the fed funds rate by .25% points, it is not pulling a lever and precisely moving the rate. Instead, it is directing the open market desk at the New York Fed to sell Treasuries until bank reserves and the money supply shrink enough so that the market prices the fed funds rate at .25% points higher.

There are discretionary decisions to be made in process of targeting the interest rate which the Taylor rule prescribes. Traders at the New York Fed’s open market desk have to decide how many assets to buy or sell to influence the rate to hit that .25% point increase.

(Usually the open market desk does not have to do much work, since the market realizes that the Fed will make any purchases or sales necessary if the fed funds rate deviates from the target.)

However, this is not the same precise control that the Fed has over, say, the discount rate. When the Fed decides to raise the discount rate by .25% points, it goes up by precisely .25% points the second the Fed makes the decision.

The Fed’s strong but not 100% precise control of the fed funds rate can be seen here:

The red line is the rate officially targeted by the Fed, while the blue line is what the fed funds rate actually was on any given day. It is especially clear from the 2008 data that the fed funds rate is not an instrument of Fed policy, but is an intermediate target influenced by the Fed indirectly.

The fed funds rate is not a lever which the Federal Reserve has the power to pull. It can merely pull other levers until the fed funds rate moves in the direction it wants it to.

The same is true of NGDP. Through its ability to create and destroy dollars (i.e. open market operations, quantitative easing, helicopter drops, or whatever you want to call it) the Fed pulls other levers until the NGDP lever moves in the desired direction. Arguably, the Fed has to pull more levers to move NGDP than it does to move the fed funds rate, but this is not obviously true.

Thus, if NGDP targeting is flawed for not specifying an instrument, so is the Taylor rule.

But the Taylor rule is not flawed for failing to specify an instrument. And neither is NGDP targeting! There is no need to set a specific rule for operating instruments to achieve a goal. It would probably be better, yes, to specify the rule in terms of an operating instrument (like, say, the price of an NGDP futures contract), but that is not reason enough on its own to dismiss NGDP targeting – just as it is not reason enough on its own to dismiss the Taylor rule.

There may be other issues with NGDP as a target, but this is not one of them.


Update: It turns out Michael Belongia makes a similar point in a 2008 paper:

"A policy instrument is an exogenous variable completely under the control of the policy authority. In the case of the Fed, reserves supplied to the banking system satisfy this definition. In the recent economics literature, however, it is common to see the federal funds rate referred to as the Fed’s policy instrument, a characterization that is improper for an endogenously determined market price. [However,] it is true that, by controlling the supply of reserves, the Fed can, over short periods of time, peg the funds rate...

"The Fed still can use the federal funds rate to implement monetary policy but it then is viewed more correctly as an intermediate target variable rather than as a policy instrument. It also should be noted at this point that the federal funds rate, as an intermediate target, now becomes vulnerable to all of the same criticisms once leveled at the money supply as a potential intermediate target variable, such as whether it can be controlled within reasonable bounds and whether, indeed, its endogeneity to the system impedes its viability as a tool of monetary policy."


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