More fun with level-targeting
December 1, 2011
Yesterday I asked whether the fans of NGDP-targeting had thought through the full implications of their models. Today I will look at another sort of level-targeting recently proposed by a former Fed economist who now works at Citi.
Nathan Sheets (pictured above left) recently declared that the Federal Reserve ought to target nominal household spending rather than an inflation rate or total spending in the economy. Robin Harding summarized the main points in yesterday’s FT:
Mr Sheets reckons that nominal consumption has several advantages over nominal GDP as a target:
- It keeps the focus on consumer prices as the measure of inflation rather than the GDP deflator. That is closer to what consumers actually experience and to what the Fed does now thus reducing the communications challenge.
- A stable path for consumption, rather than a stable path for GDP, is what consumers want and thus is closer to maximising their welfare.
- Consumption is less volatile than GDP making it easier to target. Implied but not stated is that this would lead to less volatility in monetary policy.
- Targeting consumption excludes components of GDP over which the central bank has no influence, notably government spending.
- It might be easier to rally political support for stimulative policies in a crisis: “If politicians see that consumption is well below a sustainable level—meaning that their constituents are consuming less than they could be—this might help mobilize political support for stimulative monetary policies and perhaps also incentivize supportive fiscal policies.”
It’s an interesting idea but I can see some serious issues:
- As Mr Sheets notes, setting a target for nominal consumption means that you have to make a decision about the “correct” level of savings. Mr Sheets adopts the post-recession level of 4-5 per cent but this is fairly arbitrary.
- I disagree that this would be easy to communicate to the public or that it would attract political support—I think the opposite. Might opponents depict it as “compulsory consumption” ordered by the Fed? What are manufacturers going to say if a strong dollar kills exports but the Fed keeps policy tight because nominal consumption is strong? By considering only consumers you would alienate businesses and savers from Fed policy.
I thought it would be fun to compare the “Sheets Rule” against actual consumption performance since January, 1995, just like yesterday. The reason I use January, 1995 as my starting point is because it represents a time when everything was going basically about right. Unemployment was low and stable, the personal savings rate had not yet started tanking, the current account deficit was stable and not yet destructively large, and there were no enormous imbalances within the domestic economy.
So how does the actual path of personal consumption expenditures compare with an “optimal” path defined as 5% annual growth from January, 1995?
The imbalance between actual and “optimal” consumption was even bigger than that between actual and “optimal” NGDP. This suggests that the Fed was much too loose until well after the crisis hit. Moreover, the “Sheets Standard” suggests that the U.S. economy is not far from its “optimal” level of consumption, which is probably not what he had in mind.