Nominal GDP as an indicator

Many of my contrarian opinions derive from my focus on a single macroeconomic variable—NGDP.

Consider the recent period of high inflation. Almost all economists believe the inflation was caused by a mix of supply and demand side shocks. In contrast, I believe the high inflation was all demand-side, with supply shocks playing no role at all, at least over the 2019-24 period as a whole.

Consider some data from the past 4 1/4 years:

Under 4% NGDP targeting, NGDP should have risen by 18.1% between 2019:Q4 and 2024:Q1. Actual increase was 29.0%.

Under 2% PCE inflation targeting, prices should have risen by 8.8% between January 2020 and April 2024. Actual increase was 17.8%.

Note that NGDP rising by an excessive 11% led to 9% above target inflation. That means supply shocks explain none of the total cumulative excess inflation.  Yes, supply shocks clearly played a role during certain months back in 2022.  But those negative shocks were offset by positive supply shocks during other months. The economy’s supply side has been strong—real GDP has risen more rapidly than expected, mostly due to immigration.  Indeed, given the rate of NGDP growth, we are lucky that inflation was not even a bit higher.  A positive supply shock (a surge in immigration) held inflation to a level slightly below what one would have predicted based on NGDP growth alone.

My contrarian views on the role of monetary policy in the recent inflation mirror some similarly heterodox views of the Great Recession.  I argued that the Great Recession was caused by a tight money policy in 2008.  Extremely few economists agree with me.  When I argue that the Great Recession was caused by a big fall in NGDP, people accuse me of engaging in a tautology.  In their view, a big fall in NGDP is a recession.  They confuse nominal and real GDP.  

The past 4 1/4 years clearly demonstrate that real and nominal GDP are not identical—a big NGDP overshoot showed up as excess inflation, not very fast RGDP growth.  So much for the “tautology” theory.

Another complaint is that while falling NGDP was a problem back 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 the zero lower bound in 2008–the Fed was doing normal conventional monetary policy.  Indeed in October 2008 they instituted IOR to keep interest rates from falling, i.e., to prevent the economy from overheating.

Why do my views diverge so sharply from those of my colleagues?  I see several factors.

1. If you didn’t expect an inflation surge, it’s natural to look for some sort of unexpected factor to explain the result.  Supply shocks are a handy excuse, especially given that for a brief period they were contributing 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 the surge in immigration, or the repairing of supply lines after the disruption of Covid abated.  They correctly saw negative supply shocks during certain months, but failed to see that for the past 4 1/4 years as a whole the supply situation has been excellent. 

2. Most economists are relatively supportive of the Fed’s monetary policy stance.  Thus when NGDP deviates dramatically from the 4% growth path, they are reluctant to blame monetary policy.  That would be almost like blaming the economics profession for the policy disaster.  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 how it appears when looking at indicators such as interest rates.  Rates were falling in 2008 even as money was getting tighter.  Rates rose dramatically in 2022 even as monetary policy remained quite expansionary (albeit arguably slightly less so than in 2021.)  If you misjudge the stance of monetary policy, you are far more likely to misdiagnose the cause of recession or high inflation.  This mistake is especially likely to occur when an exogenous factor (such as a housing slump) causes a big change in the natural interest rate, making the Fed’s policy rate a highly inaccurate indicator of the actual stance of policy.

My focus on nominal GDP also explains why I am not impressed by unconditional forecasts.  I notice that lots of people that were right about the inflation of the early 2020s were wrong about the effects of the previous QE programs under Bernanke.  (And vice versa.)  I am far more impressed by conditional forecasts.   What do you think would happen if the Fed allows 29% NGDP growth in the 4 1/4 years after 2019:Q4?  That’s the sort of question we should be thinking about.

While NGDP is a useful indicator, inflation and interest rates are not.  If you tell me that inflation is rising, I don’t know what that means for the economy without knowing whether the increase was due to supply or demand shocks.  If you tell me that interest rates are going to be lower, it means nothing unless I know whether the fall in rates is due to easy money or a weak economy.

Only NGDP gives an unambiguous indication of the current state of the economy.  It doesn’t tell us everything we need to know, especially in the long run.  But over the short to medium run, no other variable comes close as a way of understanding current macroeconomic conditions.

There are times when economists are tempted to ignore the signals being sent by NGDP.  Don’t do that!  Back on June 28, 2021, Jason Furman was being interviewed by David Beckworth.  Here’s Furman:

So I have some sympathy for nominal GDP targeting. . . . If we were following it now, we would already have lifted off interest rates. And we’re going to, with extreme likelihood, overshoot the nominal GDP target we were on.

So under your [Beckworth’s] framework, you’d have to make up for that with a sustained period of lower than trend on nominal GDP growth. I don’t mean that to pick on you, this experience has destroyed anyone’s plans that they wrote down before. It’s such a weird period. But to me, that says, “I’d like the Fed, if the unemployment rate a year from now is still 5.5%, I’d like the Fed to take that into account, regardless of what’s happening to nominal GDP or prices as an independent problem and issue that they need to take into account.” So I think that anything has to have a dual mandate, but do you look at nominal GDP and the like, instead of inflation? Maybe.

Ouch!  June 2021 is when NGDP was just returning to the pre-Covid trend line.  In retrospect, it was the perfect time to tighten policy to prevent an NGDP overshoot.  To his credit, Furman correctly surmised that tightening would be required to prevent an NGDP overshoot, but for other reasons he thought that was an unwise idea.  He thought NGDP was sending a misleading signal, that we should have looked at the unemployment rate (which actually is an unreliable indicator.)

With the benefit of 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.