Matt Yglesias recently referred me to this tweet:
Conor Sen may be right about the need for further interest rate cuts. But I worry about a Fed policy that focuses more on unemployment than on GDP growth. (Sen may have been referring to real GDP growth, but I will focus on NGDP growth, which is clearly the right variable for monetary policy.)
Fed policy between the late 1960s and 1981 was extremely unstable, leading to an inflationary explosion far greater than the recent episode. The cause of this policy disaster is clear; the Fed focused on the unemployment rate and largely ignored the growth rate of nominal GDP.
To be effective, monetary policy needs a nominal anchor. That’s because policymakers don’t 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. Although the NGDP targeting may not be exactly optimal, any policy errors resulting from the NGDP targeting are likely to be relatively small.
Between the late 1960s and the 1980s, estimates of the natural rate of unemployment rose higher and higher. The textbooks of the 1960s estimated the natural rate of unemployment at about 4%. In the 1980s, estimates were closer to 6%. It seems likely that the natural rate of unemployment was rising and that Fed policymakers were pursuing an impossible goal. I don’t know if there has been a recent increase in natural unemployment, but it is certainly possible. Focusing on the NGDP completely avoids the need to estimate the natural unemployment rate. There is no natural growth rate of the NGDP; it is solely a policy choice.
You may wonder whether inflation provides a nominal anchor for monetary policy. Why hasn’t the Fed given equal weight to inflation and unemployment? That kind of policy would certainly be better than a single focus on unemployment, and it may indeed be what Sen had in mind. But inflation is a flawed indicator because it is affected by both supply and demand shocks. The NGDP is a cleaner measure of demand shocks, and therefore a better target for monetary policy.