The central bank defines a target with the purpose of providing a stable nominal environment.
A nominal aggregate measure is selected as a target for the purpose of providing a stable nominal environment. If inflation is selected, inflation is the measure of focus for the central bank; if NGDP is selected, NGDP is the measure of focus for the central bank.
Under the hood, the central bank operations required to achieve the target are identical, regardless of the target selected. Central bank assets are bought and sold (or in more generally understandable terms, money is created or destroyed) to stay on target.
The practice of short term interest rate pegging as a way of indirectly achieving an inflation target is an added layer of complexity and a source of public confusion. The interest rate peg is related to the amount and type of operations required to influence credit conditions, achieve the peg and consequently the inflation target. It is inoperable when the short term interest rates reach zero and/or credit markets are dysfunctional, but under-the-hood operations are still functional and impactful.
Short-term interest rate pegging is the tool of choice for achieving an inflation target – not the only one – while the selected rate peg has very little to do with the stance of monetary policy. Low interest rates do not mean “easy money,” but rather are a sign that money has been tight.
“Easy money” comes from excessive buy operations, not low interest rates. “Tight money” comes from excessive sell operations, not high interest rates. “Excessive” is defined by the economic context in which the operations occur. Either extreme in a stable economy is destabilizing. One or the other extreme may be required, however, if the economic context has been destabilized and the nominal anchor (orientation of policy toward the target) lost.
In other words, if the economy has been destabilized by excessive sell operations, large buy operations are likely required to regain stability and to reestablish the nominal anchor.
Under inflation targeting, the Federal Reserve must keep inflation stable. If there are large up or down swings in inflation, those swings must be accompanied by compensation in order to provide a long run stable nominal environment and to be consistent with the long run nature of the mandates of price stability and full employment.
The recent rounds of QE would be required under inflation targeting, even if the annual rate of inflation exceeds 2% in the short run, given the medium run missing of the target to the down side since 2008. Inflation could rise to as much as 3.5% for a period of a few years, and theoretically must, to be consistent with the 2% long run inflation target. The opposite of QE, rounds of sell operations, would be required if the inflation target were missed to the upside by the same degree.
If we do not like the idea of 3.5% inflation as a short run goal of the Federal Reserve to compensate for missing the target, we do not like the Federal Reserve undershooting the inflation target, we do not like price stability inclusive of real factors as a primary focus, and we do not like inflation targeting as a means of providing a stable nominal environment.
NGDP level targeting approximately achieves long run price stability by stabilizing income expectations. By stabilizing long run income growth expectations, prices are allowed to fluctuate based on real factors, while nominal income growth is stable. NGDP level targeting does not require a short run goal of higher (or lower) than average inflation to be consistent with the definition of long run price stability regardless of what real economic conditions exist, and is superior to inflation targeting for this reason among others.
A NGDP level target can be defined as such to satisfy both long run price stability and full employment goals achievable by monetary policy, minimizing the likelihood either goal would become unachievable, while providing a stable nominal environment.
NGDP level targeting smoothes out the ups and downs of real economic factors while minimizing the contribution of monetary policy to the ups and downs; short term interest rates fluctuate with market conditions and there are no “easy money” booms or “tight money” busts sans policy errors.
The simplicity of NGDP level targeting minimizes monetary policy discretion and the likelihood that errors in policy execution are obscured by chaos. If the economy is destabilized by errors in policy execution, the source is more easily identifiable and policymakers can be held accountable.
I do not like discretionary monetary policy inherent in traditional monetary policy management, the selection of an inflation target and the complexity involved in the pegging of short term interest rates in order to achieve the target. I do not like it because it provides the central bank with discretion in fiscal and public policy matters, and a lever by which to punish the public when elected officials carry out its desires. It is opaque, undemocratic, and not fit for a representative republic that is governed by the rule of law.