Mark Carney is a canny fellow. No sooner had he been announced as the next Governor of the Bank of England, he stood up to discuss the need for central bankers to be radical in the way they approach the world. Carney spoke about the need for central banks to be creative, a good indication that he will not fall into the same sort of policy insanity (on Einstein’s definition) that ensnared Mervyn King. In doing so, he floated one particular idea – that central banks could target nominal GDP, rather than inflation – that has grabbed lots of attention.
Many column inches have since been filled. One challenge for such a move in the Bank of England’s remit is that the Chancellor has to be on side to champion any such change; but, to his credit, George Osborne gently demurred when pressed on this issue.
Another difficulty is that, while most people think that they know what inflation is (even if sometimes they don’t) the vagaries of nominal GDP are rather less well understood. Put simply, GDP – gross domestic product – is the national income of a country. It is the sum of all the ‘value-added’ we produce as a nation – the difference between the revenues of everything we sell, and the cost of the components (not including people and machines) that we used to produce them. The fact Carney mentioned nominal GDP is significant, as most of the time the GDP numbers that we hear about are ‘real’, or measured after subtracting inflation. In essence, nominal GDP combines the real growth rates that we all want to be positive with a broad sort-of inflation measure (the GDP deflator) which capture prices right across the economy rather than just in retailing.
This means that, by itself, a nominal GDP target may be much less of a big deal than people think. If the implicit real growth target was about 2.5%, and the implicit GDP deflator target was about 2.75% (the GDP deflator tends to rise at a faster pace than CPI) then that would imply a nominal GDP target of about 5.5% a year or so. As it turns out, the average four-quarter growth rate of nominal GDP between the end of 1993 and the start of 2008 was 5.6%. By itself, a nominal growth target wouldn’t have made that much difference before the crisis.
Instead, the big difference is that Carney suggested a level target, rather than a growth one. Under the current framework, the MPC has to try to keep CPI inflation at 2% (at all times, believe it or not). If inflation is too high in one year, the MPC is free to write that mistake off – it does not have to undershoot the inflation target in the following year to compensate. But if it had a price level target – to keep the Consumer Prices Index close to an upward trend implied by constant 2% inflation – then the Committee would have had to set policy very differently.
This is the key innovation in Carney’s suggestion. If the MPC had a nominal GDP target of 5.5% a year – and had to make up for ground lost in previous years – then the Committee would have to do even more to stimulate the economy right now.
It remains to be seen whether any of this comes to pass; Carney was at pains to set out his remarks as personal and hypothetical. I, for one, am nervous about ‘level’ targets – apart from anything else, they are far more susceptible both to data revisions and supply shocks, which can push the economy around. But the key innovation in this approach is not so much to target nominal GDP, as it is to place significant emphasis on past mistakes. In that alone, Carney has already managed to distinguish himself from Mervyn King.