Economists from the New Zealand Institute of Economic Research are urging the inclusion of a nominal GDP growth target in the Government’s upcoming review of the Reserve Bank Act.
At the moment the sole goal of monetary policy is to target inflation. The Government’s likely to want to broaden that to include employment as well.
However, in a new ‘Insight’ paper NZIER principal economist Christina Leung and economist Dion Gamperle argue that the addition of an employment target has the potential to result in conflicting signals about which way the official cash rate (OCR) should go.
“We think alternative targets should also be considered in the review, such as nominal GDP growth.”
The two economists note that targeting nominal income growth is sometimes advocated as a monetary policy regime but no central bank explicitly uses nominal GDP as a primary target.
The RBNZ in 2011 rejected the use of nominal income targeting, noting such a target was complex as GDP was subject to large revisions which made the setting of monetary policy difficult to communicate.
However, they recommend that it be considered in the review of the Reserve Bank Act, “as it considers both inflation and growth outcomes, as well as the relationship between these two variables”.
‘Overcome the drawbacks’
Nominal GDP targeting would overcome the drawbacks of monetary policy being loosened in response to positive supply shocks, which reduce inflation but boost growth.
“For example, setting a nominal GDP target of 4% annual growth would mean that interest rates would be lifted should annual nominal GDP growth be projected to be above 4% over the medium term.
“This would overcome the issue of positive supply shocks which increase output but reduce inflation, which under inflation targeting would mean interest rates be cut.
“Conversely, negative supply shocks, which decrease output but increase inflation, may mean lower interest rates should annual nominal GDP growth be projected to be below 4% over the medium term. Under inflation targeting, the increase in inflation from the negative supply shock would mean a recommendation of higher interest rates.”
By addressing both supply and demand shocks to the economy, nominal GDP targeting should deliver a better mix of inflation and GDP growth for the economy.
It would also reduce the distortions that arise from monetary policy being loosened purely in response to low CPI inflation, when asset prices are increasing strongly and GDP growth is robust, the economists say.
Fiscal policy support needed
Leung and Gamperle say that the other key element of effective monetary policy setting is that it requires the support of fiscal policy.
“The reliance on monetary policy as the only lever to lift inflation in recent years has contributed to distortions in the economy, with the effect of very low interest rates manifesting itself in very high asset prices.
“It is not realistic to expect monetary policy can be used to address all the economy’s problems,” they say.
They note that fiscal policy is projected in the Pre-Election Economic and Fiscal Update (PREFU) to be expansionary over the next few years.
“With Government expenditure expected to stimulate the economy over the next few years, this should take some of the pressure off the RBNZ to boost CPI inflation.”