Goodhart’s Law and Monetary Policy

Goodhart’s Law (named after economist Charles Goodhart) says that once an observed empirical relationship begins to be relied upon, it will no longer work.   This law, or a variant, comes up in a lot of fields, but especially finance and economics.  Consider the problem of forecasting the rate of inflation.    Price stability is a major objective of monetary policy.  Policy actions take effect over time (“long and variable lags”), therefore estimation of where inflation will be one to two years out is key to successful policy.  However, accurate forecasting has proven difficult in practice.  In particular, researchers James Stock and Mark Watson1 have examined the effectiveness of inflation forecasting rules based on various indicators; indicators like commodity prices, wage growth, money supply, and have found that no one of them consistently does better than a simple naïve rule, such as assuming next period’s inflation will be the same as today’s. 

Does this mean that economic forecasters are dropping the ball?  No, it is simply an application of Goodhart’s Law.  To see this, suppose that reliable leading indicator for inflation was discovered based on, let’s say, the price of anchovies.  Once economists at the Federal Reserve became aware of this rule – that an increase in the price of anchovies today translated into a change in the overall inflation rate next quarter – then the Fed would tighten policy when the price of anchovies went up, preventing the overall inflation and killing the usefulness of the rule.

A real world example arose in the 1970s when the Federal Reserve, relying on the excellent historical correlation of money growth and inflation, decided to target the rate of money growth in order to control inflation.  But just about the time that the Fed adopted a money growth target, the stability of the historical relationship between inflation and money growth dissolved. 

One way to attempt to overcome Goodhart’s Law is by focusing directly on your objective instead of a proxy.  When you focus on a proxy, the assumed relationship between objective and proxy is subject to change, and the proxy is subject to being gamed.  A famous example of the latter problem was the directive issued by USSR Central Planning.  When nail producers were rewarded based on the weight of nails delivered, a small number of giant nails were forthcoming.  When the reward was changed to the number of nails, millions of very small nails were delivered. 

The mandate of the European Central Bank (ECB) is low and stable inflation.  Thus, for the ECB to explicitly target an inflation rate (1.5-2%) serves as an antidote to Goodhart’s Law.  The U.S. Federal Reserve has a dual mandate, to foster both price stability and full employment.  Some economists, including FOMC members such as Ben Bernanke, have argued that the Fed should adopt an explicit inflation target.  Others fear that setting an explicit target would create the impression that the Fed was not following its dual mandate.

A better approach may be to target nominal GDP (NGDP).  Targeting NGDP automatically addresses both halves of the dual mandate.  Also, proponents argue that Fed policy would be less unstable.  In particular, NGDP targeting would call for lesser monetary policy adjustment to supply shocks than does inflation targeting.  For example, consider a negative supply shock, like at oil price spike for example.  This would tend to drive output down and measured inflation up.  If the Fed were focused on inflation then policy tightening would be in order.  This would make the output decline more severe.  Conversely, given a positive supply shock, like an increase in productivity, output would be greater and the price level lower.  Price targeting would call for an ease in policy, which could easily support asset price bubbles.  In both cases, NGDP targeting would call for lesser monetary adjustment.  Thus, in the face of a positive supply shock, NGDP targeting would be less likely to create an asset bubble, and in the face of a negative supply shock, NGDP targeting would be less likely to exacerbate the downturn.

In their meeting November 1-2, 2011, FOMC committee members discussed the merits of stating explicit targets for the price level or for NGDP.  The minutes refer to staff studies that suggested NGDP targeting could in principle be useful in supporting a stronger recovery.  However, there were a number of negative arguments raised including possible loss of anti-inflation credibility, the difficulty of setting appropriate targets and uncertainty created by making a change in policy.

These considerations are valid but not overwhelming.  I suspect that the Federal Reserve staff and FOMC will revisit this idea in the future.  By explicitly targeting the objective, the negative effects of Goodhart’s Law could be mitigated.  Sure, the connection between Fed policy instruments (e.g., the monetary base) and NGDP is subject to substantial variation.  But the essence of NGDP targeting is to make adjustments for such variation, the target being NGDP not the monetary base.

1Stock, James and Mark Watson, “Forecasting Inflation,” Journal of Monetary Economics, 1999.

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