Matt Iglesias recently instructed me to: this tweet:
Conor Sen may be right about the need for further rate cuts. However, I am concerned about the Fed’s policy of focusing more on unemployment than GDP growth. (Mr. Sen may have been referring to real GDP growth, but I will focus on NGDP growth. NGDP growth is clearly the relevant variable for monetary policy.)
Fed policy from the late 1960s to 1981 was extremely unstable, leading to an explosion of inflation far greater than the recent episode. The reasons for this policy failure are clear. The Fed focused on the unemployment rate and largely ignored nominal GDP growth.
For monetary policy to be effective, it needs a nominal anchor. This is because policy makers do not know the natural rate of unemployment or the natural rate of production. Even a small error in estimating the natural rate of unemployment can cause inflation to spiral out of control. In contrast, although NGDP targeting may not be strictly optimal, the policy error resulting from NGDP targeting may be relatively small.
From the late 1960s to the 1980s, estimates of the natural rate of unemployment rose steadily. Textbooks from the 1960s estimated the natural rate of unemployment to be about 4%. By the 1980s, estimates approached 6%. The natural rate of unemployment was rising, and it seems likely that Fed policymakers were pursuing an impossible goal. I don’t know if the natural rate of unemployment has increased recently, but it’s certainly possible. Targeting NGDP completely avoids the need to estimate the natural rate of unemployment. There is no natural growth rate for NGDP. It’s entirely a policy choice.
One might wonder whether inflation is the nominal anchor of monetary policy. Why doesn’t the Fed give equal weight to inflation and unemployment? This type of policy is certainly better than focusing solely on unemployment, and may indeed be what Sen had in mind. However, inflation is a flawed measure because it is affected by both supply and demand shocks. NGDP is a clearer measure of demand shocks and therefore a more appropriate target for monetary policy.
