In another messageI argued that two factors contributed to errors in monetary policy:
1. Having the wrong target.
2. Have an instrument setting that is unlikely to hit the target.
In the comments section John made the following statement:
I think this was a good message and the right message to respond to Tyler, but it does raise a conundrum. Your argument is essentially that policymakers should not rely on inflation forecasting models, but instead rely on market-based inflation expectations (or nominal GDP). But how should market participants forecast inflation (or nominal GDP)? I don’t think nominal GDP is high, because for this purpose it is satisfactory for the Fed to let nominal GDP be high (perhaps if the Fed actually had the objective of targeting NGDP).
I believe there are cases where “nominal GDP is high because the Fed allowed nominal GDP to be high” is a useful way to understand the problem, even if it is not a complete explanation in the deepest sense of the word.
Consider the following analogy. Fred is depressed. One day, while driving down the road, he decides to speed up his car and plow into a tree. Now consider two possible explanations for the fatal crash:
1. Fred felt depressed and committed suicide.
2. Fred’s right hand suddenly moved from a position at 12 o’clock on the steering wheel to a position at 3 o’clock on the steering wheel, causing the car to suddenly veer toward a large tree.
In a sense, the second explanation is more scientific, more ‘physics’. But most people would find the first explanation more useful.
Insiders suggest that by the end of 2021, the Fed fully understood that the NGDP was poised to rise well above trend. Outside the Fed, the same perception was widespread. Why did the Fed make this mistake? In one recent commentRajat reminds me of an exchange between David Beckworth and Jason Furman that took place in mid-2021. Here is Rajat’s response:
From the time I started reading your blog in 2011, it took me at least a few years to understand the importance of level targeting to your approach. The NGDP aspect brought you to the forefront, perhaps because it was so intuitive in the midst of a supply shock, but in retrospect it is less important. I think the reason policymakers and people like Tyler have so much trouble accepting level targeting is that it takes away an important policy outlet. I keep coming back to David Beckworth’s interview with Jason Furman on Macro Musings (as of June 2021), where Furman said:
“You established a very elegant framework for nominal GDP targeting in 2019. If we had followed it now, we would have lifted interest already. And we will, with extreme probability, exceed the nominal GDP target we set.
So within your framework, you would have to make up for that with a sustained period of lower than trend nominal GDP growth. I don’t mean to bully you, this experience has destroyed anyone’s plans they wrote down before. It’s such a strange period. But to me that says, “I would like the Fed to take that into account, if the unemployment rate is still 5.5% a year from now, regardless of what happens to nominal GDP or prices.” an isolated problem and issue that they must take into account.” So I think everything should have a bipartisan mandate, but are you looking at nominal GDP and things like that, rather than inflation? Maybe.”
It turned out that if the Fed had tightened in the first half of 2021, the US would likely have avoided most of the excessive price level growth it experienced with little reduction in employment growth. But as you noted, the US supply shocks have largely been reversed. What if that never happened and the Fed tightened anyway in the first half of 2021? Then employment might not have recovered as quickly and policymakers would have been under a lot of pressure from people like Furman.
I have enormous respect for Furman, an excellent economist. But in this particular case he was wrong; The policy had to be tightened to prevent a major exceedance of the NGDP. The Fed knew what it was doing. The country set interest rates at zero and implemented extensive quantitative easing, despite clear signs of above-trend NGDP growth. If we go back to the two types of mistakes described at the top of this post, the late 2021 mistake was clearly an example of “getting the target wrong.”
More generally: almost all of them important There are errors like this in Fed policy. Commentators occasionally point out that the 2021-2023 inflation wave was ultimately much larger than the TIPS market expected in early 2021. That is true, but this fact does not have the implications that many assume. It doesn’t mean the Fed did its best and was just unlucky. Under one level targeting regime the increase in inflation would have been much milder, with some temporary supply-side inflation but no permanent overshoot of the NGDP. The main cause of the high inflation over the past five years is that the NGDP has exceeded the 4%/year trend line by 11%. That’s a lot!
If I were to weigh my policy advice in terms of relative importance, it would be:
A 10% weight on the use of markets to guide policy. (Tactics)
A 90% weight on NGDP level targeting. (Strategy)
If you’re not aiming for the right target, being an experienced navigator doesn’t help much. Market guidance is useful, but it is not a panacea.