Early in his tenure as Fed chairman, Paul Volcker declared his intention to drive inflation lower. Soon after, he met with a group of businessmen. One told him, “'I listened carefully to you Mr Volcker, but I completed a wage agreement with my workers last week for 13% a year for each of the next 3 years. That's what I think of prospects for inflation.'” Mr Volcker recalled the conversation last year, adding, “I always wondered what happened to that guy.”

Mr Volcker's anecdote exposes the flawed reasoning behind the newborn infatuation with nominal GDP targeting. Its advocates, which include my colleague, R.A. and Goldman Sachs, now include Christina Romer. In the New York Times she says just as Mr Volcker adopted money supply targeting to defeat inflation, Ben Bernanke should adopt NGDP targeting to restore full employment. She writes:

[Volcker] believed that by backing up his commitment to lower inflation with a new policy framework, he would break people's inflationary expectations. So the Fed began to explicitly target the rate of money growth. Like the Volcker money target, [an NGDP target] would be a powerful communication tool. By pledging to do whatever it takes to return nominal G.D.P. to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth. Such expectations could increase spending and growth today

The problem with her argument is that as the story of the hapless businessman, and studies such as this one, illustrate, Mr Volcker's policy did not succeed by changing people's expectations of inflation. It succeeded by crushing demand. As unemployment moved up the Phillips Curve, inflation plummeted. Only then did inflation expectations stabilize at a lower level. (Brad DeLong provides a neat chart on page 12 of these lecture notes showing the shift in the Phillips Curve after the Volcker disinflation.) The lesson of the Volcker disinflation is that changing expectations depends crucially on delivering on the target. Naming an inflation or money supply target is helpful, but insufficient unless the central bank demonstrates it is willing and able to achieve it.

A nominal target can affect expectations in two ways. First, it influences markets' expectations of what the Fed will do, thereby amplifying monetary actions. Mr Volcker's money supply target certainly served the purpose; interest rates would soar if the weekly M1 data were higher than expected. That of course hurt growth and depressed inflation. If the Fed promised to hold rates low until NGDP returned to its pre-recession trend, that would no doubt help hold interest rates down. But there are many, potentially superior, ways to achieve the same thing, such as a promise to keep short-term interest rates at zero for a specified period of time, to target bond yields, or to keep rates low until a particular inflation or unemployment rate is achieved.

Second, a nominal target should encourage firms and workers to behave in a way that makes the target self-fulfilling. This channel is well established for inflation targeting: if workers and firms believe the Fed will keep inflation at 2%, they will tend to set prices and wages accordingly. Exactly how an NGDP target would be self-fulfillling is unclear to me: I haven't seen good empirical or theoretical evidence linking NGDP targeting to the behavior of private actors.

I'll grant, for now, that such a channel exists. For that channel to work, though, requires something else: private actors must believe the Fed can hit the target. In 1981, the Fed established that credibility by taking short-term interest rates to 20% and plunging the economy into its worst post-war recession. What, today, would give private actors equivalent confidence? Since 2007 the Fed has worked overtime to push employment higher and keep inflation from falling, which it can justify thanks to its 1970s vintage mandate of full employment and stable prices. Why would swapping its old framework for an NGDP target change this? Advocates claim this would justify a far more aggressive policy of quantitative easing. I am all in favor of more QE, but the Fed does not need a new framework to do that; its current mandate provides all the justification it needs.

So why doesn't it? The Fed now finds itself in the odd position of being blasted from one side for doing too much and the other for doing too little. There is far more substance to the latter arguments than the former, but NGDP advocates base their arguments on a flawed premise: that with a different framework the Fed would have been less concerned about inflation and more about output, and would have thus eased more aggressively.

That was true for only for a narrow window: the summer of 2008 when oil prices spiked; at the time, the Fed, worried that high headline inflation could find its way into higher expected inflation, paused in its easing, although at least, unlike the ECB, it did not tighten. But for most of 2008, the Fed was easing. Scott Sumner and other NGDP advocates claim that had the Fed been targeting NGDP, it would have responded sooner and far more aggressively.

This fundamentally misinterprets the Fed's behavior. The Fed's failure to act sooner and more aggressively was down not to its policy framework but its forecast. As late as October, 2008, it thought unemployment would peak around 7.5% in 2009 and GDP would grow slightly. It also thought inflation would fall to around 1.5%, below its long-term objective. This forecast led it to lower short-term interest rates over the next two months to zero and initiate its first round of quantitative easing. A more pessimistic, and accurate, forecast would have resulted in a more aggressive policy.

Even that earlier, less dire forecast could have justified more aggressive action than the Fed delivered; why didn't it? Because it worried that once it embarked on QE it might lack the technical and strategic acumen to exit safely later on. These fears were misplaced, but then, that is part of the reality of policy making, to which I will return.

My colleague makes an even more extreme argument: that the recession could have been avoided altogether had the Fed pursued an NGDP target. He argues that recessions could only occur because of real shocks, by which I assume he means supply-side shocks. Taken to its logical conclusion, this is like saying there is no demand shock, whatever the source—terrorist attack, asteroid strike, stock market collapse—that the Fed could not fully offset. Economic actors would tell themselves, “Ignore the asteroid strike. The Fed will ensure everything will be alright.” This is simply not compatible with theory or evidence. Even if expectations of nominal GDP had remained steady, actual NGDP would not: expectations simply aren't powerful enough. There is no monetary policy the Fed could have pursued in the face of the collapse in housing prices in 2008 and ensuing financial panic that would have kept nominal or real GDP on track.

I'm not opposed to an NGDP target, I'm only trying to bring some realism to what we can expect from one, especially in a liquidity trap when fiscal policy is AWOL. No framework is perfect; NGDP simply has to be less imperfect than the alternatives. Yet bloggers and academics have the luxury of assuming their model will work in practice as it does in theory. Policy makers must contend with the consequences if it doesn't. History is littered with busted frameworks. M1 targeting was one; Mr Volcker abandoned it after just three years, later complaining about those “damned monetarists who kept criticizing us and expecting some control of the money supply that was beyond our technical capacity. Nothing could ever satisfy Allan Meltzer.” The abandonment of M1 targeting had few consequences; the same could not be said if the euro, another flawed framework, were to fail.

Before the Fed adopts a new framework, it must conclude first that the old framework no longer works. It's worth noting that despite an unprecedented output gap, inflation has, surprisingly, oscillated around 2% rather than sliding towards deflation territory, as many expected. This is almost certainly thanks to the stability of inflation expectations which in turn is due to the 30 years the Fed has invested in keeping inflation stable. This has had important and underappreciated, benefits: it has kept real interest rates more negative, and debt burdens less crippling, than had inflation fallen to zero or lower.

However, success on stabilizing inflation has not been matched by success at getting employment higher. What alternative would work better? NGDP is not the only contender. Raising the inflation target might do the trick by making real rates more deeply negative. Charlie Evans' proposal that the Fed articulate more tolerance for upside risks to inflation in order to achieve lower unemployment is promising, because it requires no radical surgery on the Fed's existing mandate.

An NGDP target has some advantages over an inflation target, especially in responding to supply side shocks. But it could dangerously complicate policy making in more normal times. As inflation rises, the Fed tightens to keep nominal GDP on track; output then falls, but then so does inflation; the Fed must quickly loosen again. In a model developed by Larry Ball in 1996, NGDP targeting produces systematic over- and under-shooting of both inflation and output. It is “not just inefficient, but disastrous. It causes both output and inflation to wander arbitrarily far from their long-run levels.”

There is, of course, one rather unseemly advantage to NGDP targeting, that Paul Krugman alludes to here: it is a surreptitious way of temporarily raising the inflation target without the toxic politics of doing so explicitly. Many suspect that Mr Volcker never gave a damn about the money supply; a former staffer once told me of his amazement when Mr Volcker got up and left while the staffer was in the midst of briefing him on the subject.But it was, politically, a more defensible framework than simply promising to crush the economy. Mr Bernanke could take a page from Mr Volcker's book and adopt an M3 target (of course, it would have to resume publication of M3), adjusted for velocity so that it approximates NGDP. Republicans and Friedmanites everywhere would applaud. One should normally be wary of a monetary policy that achieves its objectives through subterfuge, but desperate times call for desperate measures.