What should the Fed do now? The best plan would be to announce a new target path for NGDP.
Target NGDP instead.
A vast amount of ink has been spilled on whether inflation is still a major problem in the United States and whether the Federal Reserve needs to further raise its interest-rate target to bring inflation under control.
The year-over-year inflation rate is still near 4 percent, according to the Fed’s preferred measure, the Personal Consumption Expenditure (PCE) price index, which is double the 2 percent target. Nevertheless, it has come down considerably from its near-7 percent peak last summer.
Some economists, including the Cato Institute’s Alan Reynolds, argue that metrics such as the PCE price index and the Consumer Price Index are currently overstating inflation. Those price indices calculate the housing component of inflation with a lag, so Reynolds and company believe that inflation was higher than reported in 2021 and 2022, but it is lower than reported now. Therefore, further interest-rates hike are unwarranted and could send the economy into recession.
By contrast, other economists, including Harvard professor Jason Furman, worry that core inflation, which strips out energy and food prices, has been stubbornly high. In their view, core inflation determines where overall inflation is headed next, so the Fed’s job is not done.
But what if all this focus on targeting inflation, however defined, is misguided in the first place?
A large body of research suggests that central banks should target a measure of total spending or income in the economy, such as nominal gross domestic product (NGDP), instead of inflation. NGDP growth is equal to inflation plus real economic growth. A major advantage of NGDP targeting is that it allows inflation to fluctuate in response to changes in productivity in the short run.
For example, suppose a negative supply shock such as an oil embargo or the Russia-Ukraine war reduces output and causes prices to rise. A strict inflation-targeting central bank would tighten monetary policy even as the economy suffers from this non-monetary shock. By contrast, an NGDP-targeting central bank would allow prices to naturally rise. It would only worry about keeping nominal spending on track.
The opposite scenario would be a positive supply shock such as a major technological innovation where output rises and prices fall. In this case, the inflation-targeting central bank would loosen monetary policy even though the economy is booming. An NGDP-targeting central bank would allow inflation to fall as households and firms benefit. While NGDP targeting allows inflation to vary in the short run, it stabilizes inflation in the medium to long run.
Ideally, the Fed should target the level of NGDP and not simply the NGDP growth rate. This means that it should keep NGDP on a steady path and compensate for undershoots and overshoots. If NGDP drops below path, the Fed would need to pursue a more expansionary monetary policy. If NGDP rises above path, the Fed would need to pursue a more contractionary monetary policy. With NGDP (i.e., aggregate income) on a more predictable path, members of the public can be more confident that their individual incomes will more or less be on a steady path, and they can plan their financial decisions accordingly. This helps mitigate both the dangers of recession and inflation.
Although NGDP-level targeting has many strengths, it comes with a catch: If the central bank fails to keep NGDP on its path in a timely manner, the goal becomes more difficult to achieve. The chart below illustrates why.
The blue line shows actual NGDP from 2014 to present. The orange line shows a simple counterfactual NGDP from 2020 to present based on the pre-pandemic trend. We see NGDP clearly fell in 2020 at the onset of the pandemic. The Fed was right to inject enough liquidity into the economy to bring NGDP back to the forecasted path around mid-2021. But then it erred by allowing NGDP to overshoot this path. The Fed should have spent the past 18 months trying to bring NGDP back down to its forecasted trend. Unfortunately, it hasn’t, and the gap between the two lines has only gotten larger.
As the American Institute for Economic Research’s William Luther points out, although the Fed should have been working to bring NGDP back to its pre-pandemic path, Chair Powell and other Fed officials have spent months reiterating that they are instead simply interested in bringing inflation down to 2 percent. Now, the public no longer expects anything close to a return to the pre-pandemic trend, so attempting such a return would be destabilizing and counterproductive.
What should the Fed do now? The best plan would be to announce a new target path for NGDP. There are at least two reasonable paths. First, the Fed could pick a numerical target consistent with low inflation over time. For example, if the Fed wants 2 percent inflation on average, it could pick a 4 percent NGDP target path (assuming real GDP grows also grows at 2 percent on average). Second, the Fed could target some proxy for what markets and the public expect NGDP to be. For example, the Mercatus Center at George Mason University publishes a measure called the NGDP Gap, which is calculated from a rolling average of publicly available forecasts.
Although inflation has been falling since its peak last summer, the Fed’s failure to predict and counter both high inflation and nominal GDP growth has strained its credibility. Let’s hope that the Fed switches to a better goal and is committed to doing whatever it takes to achieve that goal going forward.