Among economists following an idea known as “market monetarism”, one of their core proposals is that the central bank should “target” a specific annual rate of increase in the nominal GDP figures, which are not adjusted for inflation. Typically, this involves targeting an NGDP annual growth rate of something like 5%. This, it is promised, will go far to ensure that the central bank responds appropriately in its monetary policy to prevent the economic cycle of booms and busts and ensure prosperity.
It doesn’t take much to see, however, that this can easily lead to some rather absurd scenarios. Naturally, we can imagine a scenario where the NGDP target of 5% is exceeded by measures of annual inflation. If we see a price inflation rate of, say, 7% (a high, but not unheard of, figure), then the NGDP target entails shooting for negative real growth. Rather, not only is one solution to high inflation to intentionally shrink the real economy and make everyone poorer, if we end up with a scenario where the economy is shrinking as inflation in prices is high, the NGDP targeting central bank might not notice a problem at all. Which would be good, insofar as central bank interventions seek to prevent the necessary and natural adjustments by individuals to changing economic conditions, except for the fact that inflation is a product of central bank monetary production. Such a central bank would be compounding the shrinking of the economy with an added dose of the destruction of purchasing power, in a cycle that can easily build to national economic collapse.
It does no good to assume that this sort of “recessionary inflation” can’t occur in practice. Even recent history puts the lie to that suggestion. Real GDP decreased 3.5% in 2020, according to the US government statistics, while the inflation rate of the US CPI ended up at 1.4%. Despite shrinking significantly, the NGDP targets are almost spot on in the “recovery”. In 2021, the CPI has just hit 5% year-over-year for May, implying that the ideal real GDP change is none at all in that timespan: which would essentially demand that no recovery from the lows of the government-imposed lockdown of large swaths of the global economy should have been done. This is patently absurd; the mind is completely boggled even thinking about it.
Yet, this is not the only sort of scenario where NGDP targeting leads to absurd conclusions. Even under a more “normal” situation for an economy with these central bank targets, the result of a recession is to intentionally target massive inflation. Assuming a recession of even a 10% drop in annualized real GDP, the annualized inflation rate to “counter” this decline and still hit the target would have to reach around 15%!
An apparently simple solution can be sought here. A lot of these recessionary drops are short-term drops followed by recovery that mostly averages out. So we can just do NGDP-targeting in the long term, right? Instead of month-by-month, we can look at the average rates over the last year or more. This seems fairly intuitive, but it doesn’t actually solve the problem. NGDP-targeting is purported to be a mechanism that will reduce recessions and smooth out the future, but going off of averages from the recent past slows responses and changes. If, hypothetically, action can be taken to prevent or reduce the severity of recessionary drops in economic output, that action must be timed properly, not adopted after the fact when NGDP targets are being blown.
NGDP targets make no distinction between a high price inflation with low or negative real output growth or low inflation with high output growth. Fundamentally, it must be assumed that “real growth” follows a trend baseline (often assumed to be 2 or 3 percent) in “normal” times for it to seem reasonable at all. And with that assumption, what it essentially comes down to is the conclusion that in a “supply shock” (say, for instance, the government forcibly outlawed the operation of half the economy for most of a year), price increases above a couple percent should be lived with and not countered by the central bank.
Recently, we have seen that central banks wouldn’t attempt to do that anyway: faced with a “supply shock” of epic proportions created by the governments of the world, central banks the world over are declaring inflation “transitory” after printing massive sums of money to keep financial markets afloat and provide bailouts to companies that were forbidden by executive decree to operate. If and when this inflation proves to not be “transitory”, but rather a long-lasting consequence of large amounts of money being created at the same time production in many industries was slowed, halted, or redirected by government fiat, it will be far too late for any sort of NGDP targeting. The risk, rather, is that a central bank facing a crisis will throw away its targets (whether of price inflation or GDP) and simply dive into “emergency mode”, creating gobs of currency to provide “liquidity”, dropping interest rates to the floor, and working to stymie market processes of adapting to changes in supply and demand.
