Many of my contrarian views stem from my focus on a single macroeconomic variable: NGDP.
Consider the recent period of high inflation. Almost all economists believe that inflation was caused by a combination of supply and demand side shocks. In contrast, I believe the high inflation was entirely demand-driven, with supply shocks playing no role, at least over the entire 2019-24 period.
Consider some data from the last 4 1/4 years:
Under the NGDP target of 4%, the NGDP should have increased by 18.1% between 2019: Q4 and 2024: Q1. The actual increase was 29.0%.
Under the 2% PCE inflation target, prices should have increased by 8.8% between January 2020 and April 2024. The actual increase was 17.8%.
It is worth noting that the excessive increase in the NGDP by 11% led to inflation being 9% above target. This means that supply shocks do not explain any of the cumulative total excessive inflation. Yes, supply shocks clearly played a role in some months of 2022. But these negative shocks were offset by positive supply shocks in other months. The supply side of the economy has been strong: real GDP has grown faster than expected, mainly due to immigration. Indeed, given the growth rate of the NGDP, we are lucky that inflation was not even a little higher. A positive supply shock (a surge in immigration) kept inflation slightly lower than would have been predicted based on NGDP growth alone.
My contrarian views on the role of monetary policy in recent inflation reflect some equally heterodox views on the Great Recession. I have argued that the Great Recession was caused by restrictive monetary policy in 2008. Very few economists agree with me. When I claim that the Great Recession was caused by a major fall in the NGDP, people accuse me of engaging in a tautology. According to them, a sharp drop in NGDP is a recession. They confuse nominal GDP and real GDP.
The last four and a quarter years clearly demonstrate that real GDP and nominal GDP are not the same: a significant overshoot of the NGDP resulted in excessive inflation and not very rapid growth in the RGDP. So much for the theory of “tautology”.
Another complaint is that even if the NGDP crash was a problem in 2008, there was nothing the Fed could have done about it because we were stuck at the zero lower bound. But we were not at floor zero in 2008: the Fed was conducting normal conventional monetary policy. Indeed, in October 2008, they instituted the IOR to prevent interest rates from falling, that is, to prevent the economy from overheating.
Why do my opinions differ so sharply from those of my colleagues? I see several factors.
1. If you weren’t expecting a surge in inflation, it’s natural to look for an unexpected factor to explain the result. Supply shocks provide a convenient excuse, especially since for a brief period they contributed to higher-than-normal inflation. But this is motivated reasoning. Economists often overlook the fact that the economy is also continually hit by positive supply shocks, such as rising immigration or repairing supply lines after Covid disruptions subside. They saw, rightly, negative supply shocks in some months, but failed to see that the overall supply situation had been excellent over the past four and a quarter years.
2. Most economists are relatively supportive of the Fed’s monetary policy stance. So when the NGDP deviates significantly from the 4% growth trajectory, they are reluctant to blame monetary policy. It would almost be like blaming the political disaster on the economists. It is much more satisfying to seek explanations involving mysterious “exogenous shocks.”
3. The direction of monetary policy is often very different from what it appears when looking at indicators such as interest rates. Rates fell in 2008 even as liquidity tightened. Rates rose dramatically in 2022, although monetary policy remained quite expansionary (although arguably slightly less than in 2021). If you misjudge the stance of monetary policy, you are much more likely to misdiagnose the cause of recession or high inflation. This error is particularly likely to occur when an exogenous factor (such as a housing crisis) causes a significant change in the natural rate of interest, making the Fed’s policy rate a very imprecise indicator of the real direction of its policy.
My interest in nominal GDP also explains why I am not impressed by unconditional forecasts. I notice that many people who were right about inflation in the early 2020s were wrong about the effects of previous quantitative easing programs under Bernanke. (And vice versa.) I’m much more impressed by conditional forecasts. What do you think would happen if the Fed allowed NGDP to grow by 29% over the four and a quarter years following the fourth quarter of 2019? This is the kind of question we should be thinking about.
While NGDP is a useful indicator, inflation and interest rates are not. If you tell me inflation is increasing, I don’t know what that means for the economy without knowing whether the increase is due to supply or demand shocks. If you tell me interest rates are going to go down, it doesn’t mean anything unless I know whether the rate drop is due to easy money or a weak economy.
Only the NGDP gives an unambiguous indication of the current state of the economy. This doesn’t tell us everything we need to know, especially in the long term. But in the short and medium term, no other variable allows us to understand current macroeconomic conditions.
There are times when economists are tempted to ignore the signals sent by the NGDP. Do not do that ! Back on June 28, 2021, Jason Furman was interviewed by David Beckworth. Here is Furman:
So I have some sympathy for targeting nominal GDP. . . . If we followed it now, we would have already raised interest rates. And we will, with extreme probability, exceed the nominal GDP target that we had set.
So, according to your (Beckworth’s) framework, you will have to compensate for this with a prolonged period of below-trend nominal GDP growth. I don’t want to blame you, this experience destroyed someone’s plans they had previously written. It’s such a weird time. But to me that means, “I would like the Fed, if the unemployment rate in a year is still 5.5%, I would like the Fed to take that into account, regardless of what happens to nominal GDP or at prices. a problem and an independent question that they must take into account. So I think everything has to have a dual mandate, but are you looking at nominal GDP, etc., rather than inflation? Maybe.
Ouch! In June 2021, the NGDP was just returning to the pre-Covid trendline. In retrospect, this was an ideal time to tighten policy to avoid overshooting the NGDP. Admittedly, Furman correctly assumed that tightening would be necessary to avoid overshooting the NGDP, but for other reasons he thought it was an unwise idea. He thought the NGDP sent a misleading signal that we should have looked at the unemployment rate (which is actually an unreliable indicator).
Looking back, we can clearly see that the NGDP signal was absolutely correct and Furman was wrong. It was time to tighten up.
Ignore NGDP at your own risk.
