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The best policy might be some kind of NGDP targeting in the short run, but with a slowly adjustable "bias" which ensures that the overall price level grows on a predictable path, thus satisfying the mandate of overall price stability.

I think the Taylor Rule is supposed to work similarly, but I'm not really sure. Does this policy have any issues compared to simple NGDP or price level targeting?

Apart from looser fiscal policy in Canada relative to the UK, we also had more robust household spending throughout the recession. I would therefore expand on Point #1 in your list of differences between the UK and Canada during this recession by adding:

1a. UK banks went bad, ours didn't, so Canadian banks were still willing to extend credit;
1b. UK house prices tanked in 2008, Canadian house prices did not, so Canadians still retained a lot of their home equity (and, therefore, had lots of collateral);
1c. By having access to credit, and by taking advantage of historically-low interest rates, Canadian households spent their way through the recession.

The most striking feature of this recession is that households in this country behaved as if it never happened (see Chart 13 in the BoC’s Jan 2011 Monetary Policy Report). The brunt of the recession was felt by net exports (not surprising, considering the economy of our largest trading partner went AWOL), and business investment (with tales of Great Depression II dominating headlines, risk premia on corporate bonds went through the roof in 2008-09, so lower policy rates had little impact on corporate borrowing rates).

Meanwhile, Table 2.A in the Feb 2011 Bank of England Inflation Report shows that virtually all GDP components in the UK were falling in the first half of 2009.

In short: Canadian GDP recovered more quickly than the UK thanks to higher G and C, which can be traced to healthier banks and the lack of a housing bubble. I think, in this instance, this has more to do with our regulatory framework rather than the choice of monetary policy target.

VAT increased twice in the UK in the last 2 years, from 15% to 17.5% in Jan 2010 and from 17.5% to 20% in Jan 2011.

"The UK has had to tighten fiscal policy"

They did. They didn't have to.

UK experience a reflection of what happens when you run pro-cyclical fiscal and monetary policy for a decade leading to real estate bubbles, excessive aggregate debt (and government). Despite a 25% depreciation in the currency, the UK still has a current account deficit telling something about how uncompetitive it became. Also, UK had bigger QE program as % of GDP then USA so inflation should be a problem ... payback time for years of loose policy.

Canada should keep its 2% target but policy makers should now be very wary of aggregate Canadian debt getting to USA levels per capita.

As for Sumner, folks have a tendency to think that just because the US economy is more closed that policy ramifications isolated to domestic economy. This is most definitely not true as it omits the impact of the numeraire in the pricing of all products for which markets are global i.e. commodities.

anon: yes, suppose we wanted (say) 2% inflation on average in the long run. If we forecast (say) 3% LR GDP growth, we could target 5% NGDP. And if the forecast fell to 2% LR GDP growth, we could change the target to 4% NGDP. But: our ability to forecast LR GDP is not that great; it puts a bit too much discretion in the rule.

I think of the Taylor Rule as a way to implement inflation targeting, rather than an alternative to inflation targeting.

Greg: Yep. Good points on the differences between Canada and the UK. But, will we always be this lucky? Could it ever happen here? I think it could.

Matteo. Thanks. I've changed the post. I didn't Google deeply enough.

crf: Perhaps a better way of putting it would be like this: Canada went into the recession in better fiscal shape than the UK. So Canada was under less pressure to tighten fiscal policy.

Nick, the ONS publishes a constant indirect taxation cpi series. Latest YoY print was 2.3%. The BoE is nearly right on target.

"But: our ability to forecast LR GDP is not that great; it puts a bit too much discretion in the rule."

Assuming that NGDP- and inflation-indexed securities exist, wouldn't asset markets be doing the forecasting? This would not be "discretionary" in any real sense.

Adam: thanks. ONS= Office of National Statistics? I'm so out of touch with the UK. If I were the Bank of England, that is exactly the sort of thing I would be pointing to. But it's still what I've been calling a "finesse". If we exclude indirect taxes from the CPI, why? And why stop there? I could maybe sketch out an answer (I think I did sketch out an answer, back in my old post http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/09/targeting-the-stickiest-price.html ). But one of the main arguments in favour of inflation targeting is transparency, and if we keep fudging over what we do and do not include in the CPI, that transparency is lost.

anon: OK, assume those futures markets exist. And that we target market forecasts of NGDP over the "short run" and market forecasts of CPI over the "long run". We still need some formula to tell us how long is the long run, and how much we adjust the short run to the long run.

I don't think the current UK experience is a good example of the failure of divine coincidence. Think about it: Would you rather have had the UK experience with inflation or that of the US over the last two years? The Bank of England isn't facing a conflict between different objectives--it should admit that it is not upset but in fact should take credit for generating higher inflation in the current environment. At the zero lower bound for the policy rate, there are good arguments for raising expectations of inflation (and hence realizations of inflation) above the usual target. This lowers the real rate at short maturities and should help the UK exit the recession more quickly.

Unfortunately, by apologizing rather than taking credit for the higher inflation, it looks like the BoE has lost control of inflation and that hit to its credibility is going to make a return to a lower inflation target more costly.

Canada's CPI includes GST: see this technical note.

Canadian GST was cut by one percent in Jan 1, 2008. July 1 2010 provincial sales taxes were replaced with harmonized sales taxes in Ontario, which probably bumped up CPI a little bit.

Nick, is this good for your story or bad for your story?

The UK is in a similar situation as Spain and Ireland. Bad loans, property bubbles etc etc...

Rather than re-balance nominal wages down through austerity attrition, inflation is doing the heavy lifting on real wages. Now it's just a balancing act between expectations and observed, making sure the former doesn't become unhinged. Watch King spend the next year or two with meticulously worded speeches while inflation creeps higher.

In 2009 the BoE pension board moved 70 pc of it's fund into inflation-indexed bonds. As Mr. Jerry Macguire once said...

On nominal GDP - I'm an adept of the glorious system of national accounts. But it does not tell us the whole economic story, when it comes to money, inflation and MV = PT.

GDP accounting typically leaves out 'second hand trade', as this does not generate value added (aside from some fees). But do not underestimate the monetary importance of the second hand trade:

* the second hand car market is, in monetary terms, larger than the first hand market
* even more so for the housing market
* e-bay has gained some importance, during the last decade or so
* the old fahsioned yard sale has not disappeared
* the entire stock market is a second hand market, except for issues of shares
* ancient art and antiquities are also second hand

Value increases in these markets are (rightly) not seen as an increase in value added and available services and goods and therefore not included in GDP and neither are their prices. However - money is used to pay for these items. Monetary policy should not only take account of GDP-prices, but also of second hand prices. The PT part of MV = PT does include second hand trade. Targeting nominal GDP is targeting only the sunny side of the mountain, the shadowy side has to be included to.

P.S. - its, alas, nevessary to state that I'm convinced that al the MVPT items can 'prime-move' somewhat independent from each other. The housing market is a fine example. In the upward moving phase of a housing cycle, more money (read: cheaper and easier mortgages) leads to price rises, which are sometimes, but not always, followed by an increase in the number of transactions. In the present, downward phase, less money (more expensive and more difficult to become mortgages have a different consequence: loss aversion however leads to sticky prices and to a decline of the number of transactions, instead of prices, which only follow with a sometimes considerabe lag (a staple of Georgist economics, this one, by the way).

Merijn - and if people are abandoning geolocal life for Second Life, World of Warcraft, etc., nominal GDP is an even worse measure of economic well-being.

It seems likely that U.K. inflation is largely due to rises in import costs. It seems unwise to try to reduce such inflation by tight monetary policy. Perhaps we should target an inflation rate that ignores such import effects. Perhaps targeting wage inflation would be better.

Are figures on wage inflation or other measures that take out imports published?

I believe inflation in Britain is "overstated". A few days ago I did a post arguing in that direction:

Merjin Knibbe, the second-hand market has more price flexibility than the primary market, so it is less sensitive (if at all) to business cycle fluctuations and shifts in monetary policy. The only exception I can think of is housing, and we can use sector-specific indicators for that.

Nick, Very good post. A few comments:

1. I have an open mind regarding NGDP targeting for smaller open economies. I've always that that nominal wage rate targeting was optimal, but for all sorts of reason was not feasible. Hence NGDP targeting was a sort of second best. For small open economies, NGDP and average nominal wages might occasionally diverge quite sharply.

2. I think there is an argument for excluding VAT from the CPI, for monetary policy purposes. Faster CPI growth is supposed to signal an overheating economy, and too much hiring. But that's only true if the companies are actually receiving higher prices, in net terms. But if the CPI only rises due to higher VAT, then companies aren't actually receiving any additional net revenue.

Angelo: I agree that the BoE has done well to prevent expected inflation falling. Yes, it could have done worse. But it has totally failed to stop NGDP (and RGDP) from falling. I don't want to say that AD was growing strongly enough over the last 3 years. But if I judge it according to inflation targeting, that's what I am forced to say.

Frances: the Canadian GST cut, contrasted to the UK VAT increases, adds to the explanation of the divergence between the Canadian and UK experiences. But, we can imagine the situations were reversed, where Canada were the one which was experiencing GST increases and a depreciating exchange rate during a recession, so that the BoC would face a conflict between keeping inflation on target and fighting the recession.

Mark: I don't know what's been happening to nominal wages in the UK. But I agree that the BoE's communication strategy will be very difficult, if it wants to keep expected inflation anchored.

Merijn: you lost me there. Sure, we can complain about NGDP in a number of ways. But, in this case, it does seem to be telling us something more reasonable than CPI. NGDP says the UK had a recession. CPI says it didn't.

Paul: there is published data on wage inflation. And, if you believe that wages are the stickies price, there's a lot to be said for targeting that stickiest price. Politically though, you can imagine the howls from the ill-informed "The Bank of Canada is trying to stop us getting wage increases!"

Marcus: good post! Everyone: if you follow the link in Marcus' post above, he does some good graphs comparing UK and US inflation, and explains the disconnect as due to the UK VAT increase plus the depreciation of Sterling. Confirms my hunch.

Scott: thanks! As you see, I'm still sitting on the fence between CPI and NGDP. This is the nearest I have come towards your position. The other big difference between Canada and the US is that the US doesn't have an existing formal target, so is not biased towards the status quo in the way Canada is. It is easier to advocate NGDP ex nihilo, than to advocate a switch from CPI to NGDP, especially since CPI has served Canada quite well so far.

The graph would be more helpful if it were plotted on a log scale.

So go ahead and make one, and give us a link. Jeez.

On the one hand, one reason given for Australia's weathering the storm so well is that it had almost 4% inflation in 2007, which gave it a cushion, so that it never approached the dreaded zero bound. As against that, there are people in Canada recommending a 1% inflation target?


What gives, Nick?

Thanks. :)

If someone is getting raises then it ain't me or any of the proletarians I rub elbows with. In more than a decade of working I have never once had a raise. The only way I ever got a pay rise was to change jobs. Now that may say more about me and my abilities than anything else (or perhaps my profession) ... nonetheless, given my experience I would happily hand over wage inflation control to the BoC - if only to witness the spectacle of hedge fund managers, hockey players and CEO's (to name a few) having their bonus squashed by Mark Carney. I can see it now: NO SOUP FOR YOU!

@M Kelly
I did the graph in log scale. There is no visually detectable difference. The range of the data is too small to make it noticeable. The info Nick wanted to show is well represented in the linear scale graph.

At the risk of appearing a moron, could someone please explain Angelo's comment to me?

"I don't think the current UK experience is a good example of the failure of divine coincidence."

As I read Nick, "Divine Coincidence" is the coincidence of an inflation target being a pretty good policy for real growth.

As I read Angelo, he's claiming that that a third coincidence, the zero-lower bound, means that missing the inflation target is good for growth just now.

Angelo is a pretty smart guy and I'm reading this at 6:30 am. What am I missing here?

It's a matter of balancing growth in demand with growth in supply. Inflation is a form of sharing of real profits, where the real profits of business are shared with labor.

Inflation is, among other things, a redistributionalist tax on business profits. It distributes demand, money, to the rest of the economy, where otherwise business would retain the entire real profit, and all the increase in demand. 'Taming' inflation would then result in businesses then growing, but demand in the rest of the economy would not, leading to an excess of productive capacity, and the woes that accompany this. So rather than seeking to decrease the inflation rate, the BOC would do better to increase the rate slightly, to say 3% if the average of nominal business profits is 6%, 4% if the average of nominal business profits is 8%, etc.

Seeking to balance the growth of demand with supply, it would seek an inflation rate roughly half of the average rate of nominal business profits. That is it would seek a growth of the money supply a few percent more than the real rate of growth of GDP, so each sector grows at the same rate.

Excess inflation, of course, is disruptive to business profits, and leads to an excess of demand over supply. These considerations indicate how adjusting the inflation rate can be used to regulate an economy.

Greg, inflation is defined as a relative change in the price level, although some people use the word to mean a change in money supply. Why would these have anything to do with real labor income? If anything, the consensus among economists is that low or negative inflation may raise real wages to an excessive level, and unemployment may result.

Min: That was my reaction. The ZLB used to be a theoretical possibility. Now we experienced it first hand. OK, Canada has survived this recession fairly well, but all the same. I'm trying to think of the right metaphor. "That big truck just missed us, so we can drive nearer the white line".

Patrick: now, you know it wouldn't mean the BoC setting individual wages!

Marcus: thanks. Yep, at that range, it shouldn't matter. 102/100 = 110/108.

Simon: 6.30=12.41? You must be in Germany? I was a bit puzzled by Angelo's comment too. Like the rest of us, he was probably worried to distraction by the fear of expected deflation. So any central bank that avoids that has done well.

Greg: you lost me there. I can't think of any economic model that would generate those effects of inflation.

Yeah... but wouldn't they need to some lever to pull to cap wage increases? Off the top of my head, the only thing I can think of is to limit/mandate pay rises.

Yes, Australia had high headline inflation in 2007, but so did New Zealand. I did this post to show that MP in Australia is consistently better than New Zealand´s. And this is true both in the present crisis and in the Asian crisis of 1997-98!

Patrick: no. In principle targeting wage inflation is no harder than targeting price inflation. If average wages (prices) start to rise more quickly than the target, just tighten monetary policy.

Marcus: I enjoyed reading your post on Australia and NZ. Here's my old post on a similar subject: http://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/canada-australia-and-new-zealand.html

Of course. Stupid of me. Brain not working. Same machinery, different gauge. I guess I had the same early morning syndrome as Simon.

Nick: I was waking up (or trying to) in Zurich, but I'm writing this from Luxembourg. Same time zone, different currency.

I remembered readind your post back in the day. I was always fascinated by the "natural experiment" regarding MP that NZ and Australia provide. Back in 99 I had done that comparison and its interesting to see that Australia "beats" NZ everytime! But over the last 12 years it seems NZ has learned something...
On a related topic, at present many are very concerned about the inflationary impact of oil and CB reactions.
I got hold of this 1997 piece by Bernanke and al.
The abstract reads:
Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock. Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se.

I´m not too optimistic. In the past he showed that he understood Japan´s problem (lack of AD), but when his turn to act came along in 2008, he "failed" miserably!

Nick Rowe: "That big truck just missed us, so we can drive nearer the white line".

Thanks, Nick. :)

I can't understand Angelo's comments also. the divine coincidence has nothing to do with the fact that the BOE is allowing inflation expectations and realized inflation to increase so that real rates keep falling, thereby stimulating the economy. But as Nick pointed out NGDP and RGDP have both been falling in the UK.

What about all the work that has pointed out that NGDP targeting like Price level targeting is bad when inflation expectations are backward-looking? Moreover, how easy is it to communicate that you are targeting NGDP?

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