Many of my objections stem from the focus on a single macroeconomic variable: NGDP.
Consider the recent period of high inflation. Nearly all economists believe that the inflation was caused by a combination of supply-side and demand-side shocks. In contrast, I believe that, at least for the entire 2019-2024 period, the high inflation was all demand-side, with no supply shocks at all.
Let’s look at the data for the past four years and seven months.
With a 4% NGDP target, NGDP should have increased by 18.1% between Q4 2019 and Q1 2024. The actual increase was 29.0%.
Under a 2% PCE inflation target, prices should have risen 8.8% between January 2020 and April 2024. They actually rose 17.8%.
Note that NGDP rose by 11%, exceeding the target inflation rate by 9%. That is, the supply shock was Total Accumulation Excessive inflation. To be sure, supply shocks played a role in certain months of 2022. But those negative shocks were offset by positive supply shocks in other months. The supply side of the economy was strong, and real GDP rose faster than expected, mostly due to immigration. In fact, given the growth rate of NGDP, we were fortunate that inflation did not get any higher. The positive supply shock (the immigration surge) kept inflation at just below the levels that would be predicted based on NGDP growth alone.
My dissenting views about the role of monetary policy in recent inflation mirror similar heretical views about the Great Recession. I have argued that the Great Recession was caused by tight monetary policy in 2008. Very few economists agree with me. When I argue that the Great Recession was caused by a large drop in NGDP, people accuse me of equating the two. In their view, a large drop in NGDP is a It’s a recessionThey confuse nominal GDP with real GDP.
The past four years and five months have clearly demonstrated that real GDP and nominal GDP are not the same thing: it is large excesses in nominal GDP that show up as excess inflation, not rapid growth in RGDP. So much for the “tautology” theory.
Another complaint is that in 2008, the Fed was unable to do anything about the declining NGDP because it was at the zero lower bound. However, the Fed was not at the zero lower bound in 2008 and was conducting normal conventional monetary policy. In fact, in October 2008, the Fed introduced the IOR to prevent interest rates from falling, i.e., to prevent the economy from overheating.
Why does my opinion differ so dramatically from my colleagues’ opinions? There could be a few factors.
1. If we did not expect an inflation spike, it is natural to look for some unexpected factor to explain the result. Supply shocks are a convenient excuse, given that they have been the cause of higher-than-usual inflation, especially in the short term. But this is motivated reasoning. Economists tend to overlook the fact that the economy is also hit by ongoing positive supply shocks, such as a surge in immigration or repairs to supply lines after the coronavirus disruptions subsided. They correctly identified negative supply shocks in certain months, but failed to realize that supply conditions have been generally favorable over the past four and a half years.
2. Most economists are relatively supportive of the Fed’s monetary policy stance. So when NGDP deviates significantly from its 4% growth trajectory, economists hesitate to attribute blame to monetary policy, much like they would blame the economics profession for policy failures. It is much more satisfying to look for explanations that involve mysterious “exogenous shocks.”
3. The stance of monetary policy is often very different from what it appears to be when measured by interest rates and other indicators. In 2008, interest rates were falling amid tightening monetary policy. In 2022, interest rates rose dramatically, even though monetary policy was still fairly expansionary (albeit slightly more accommodative than in 2021). Misjudging the stance of monetary policy increases the likelihood of misdiagnosing the causes of recessions and high inflation. This mistake is especially likely when exogenous factors (such as a housing market downturn) cause the natural rate to shift significantly, making the Fed’s policy rate a very inaccurate indicator of the actual policy stance.
The focus on nominal GDP also explains why I am unimpressed with the unconditional forecasts. I find that many people who were right about inflation in the early 2020s were wrong about the impact of the previous QE program under the Bernanke administration (and vice versa). I am of the opinion that Conditional ForecastingIf the Fed allows NGDP to grow at 29% over the next 4.5 years from Q4 2019, what do you think will happen? This is the kind of question we should be thinking about.
NGDP is a useful measure, but inflation and interest rates are not. Being told that inflation is rising doesn’t mean anything to us unless we know whether the rise is due to a supply or demand shock. Being told that interest rates are falling doesn’t mean anything to us unless we know whether the fall in interest rates is due to easy monetary policy or a weakening economy.
NGDP alone gives a clear picture of the current state of the economy. It doesn’t provide all the information you need, especially in the long term. But in the short to medium term, no other variable comes close to NGDP as a way to understand the current macroeconomic situation.
Economists are sometimes tempted to ignore the signals coming from NGDP. But don’t do that. June 28, 2021 Jason Furman David Beckworth was interviewing him, and Furman says,
So I have some sympathy for nominal GDP targeting because if we were to do that now, we would have raised interest rates already, and we would very likely end up exceeding the nominal GDP target that we had set.
So in your framework, you have to make up for that by having sustained periods of below-trend nominal GDP growth. I don’t blame you. This experience has ruined the plans that everybody had before. It’s a very strange time. But to me, that sounds like you’re saying, “If unemployment is still 5.5% a year from now, I want you to take that into account, regardless of what’s happening to nominal GDP and prices.” That’s an independent issue or challenge that needs to be taken into account. So I think there should be a dual mandate for everything, but are you looking at things like nominal GDP and not inflation? Maybe.
Ouch! June 2021 was a time when NGDP had just returned to its pre-COVID trend line. In retrospect, it was the perfect time to tighten policy to prevent NGDP from overshooting. Furman deserves credit for correctly guessing that tightening was necessary to prevent NGDP from overshooting, but he thought it was a bad idea for other reasons: he thought NGDP was giving a misleading signal and that we should have focused on the unemployment rate (which is actually an unreliable indicator).
In hindsight, we can clearly see that the NGDP signal was exactly right and Furman was wrong: it was time to tighten.
Ignore NGDP at your own risk.
