An interesting story almost slipped below radar last weekend, as headlines filtered in from Jackson Hole and followed Irene's path across the US mainland.  I think it was the most interesting story of the weekend and worth some attention.

Current high rates of inflation are throwing up issues for central bankers.  With inflation consistently higher than target in many countries, do they hike to stem this menace and risk any 'green shoots' turning brown, or allow inflation to tick higher and trust their models that it will fall 'in the medium-term'?

The Economist has highlighted an alternative – shifting target from Consumer Price Index (CPI) to Nominal Gross Domestic Product (NGDP).

Real GDP tells us the annual growth in an economy after adjusting for inflation.  The nominal version provides us with GDP figures before this adjustment.

"To adopt NGDP targeting, central bankers would set or be given a goal for how fast it should grow, most likely an annual rate of 4-5%. That corresponds in most rich countries to inflation around the 2% target now generally preferred and long-term potential growth of 2-3%. Monetary policy would then react as it does now, easing when NGDP growth was expected to be too sluggish and tightening when it was expected to be too exuberant. – The Economist

Such a switch could have great ramifications as to when and how central banks react to economic shocks – growth as well as inflationary.  The same weapons would be in their armoury – interest rates and asset purchases – but NGDP targetting would allow greater flexibility when needed, in theory at least.

Given the current state of the financial world, a switch would allow central bankers room for further asset purchases (aka Quantitative Easing) to support a fragile economy – especially important with interest rates at-or-near record lows, so less effective to stimulate growth.

Potentially, continued weakness in underlying growth could be offset by letting inflation run higher – resulting in a higher NGDP. 

It could also mean lower long-term interest rates if asset purchases become the main weapon to fight an economic downturn, especially while fiscal policies in the US, UK and elsewhere are being tightened.

As for the effect on real yields, a wise trader once told me: "He who tries to pick bottoms often ends up with smelly fingers."
Click here for the full article from Economist.


[Please note that all opinions expressed in this blog are the author’s own and do not constitute investment advice.  Click here for full disclaimer]