(Bloomberg Opinion) -- Suddenly the Federal Reserve seems to agree with critics who say its efforts to control inflation have come too late. Its delay has given inflation longer to get entrenched, and now that the Fed is hurrying to catch up, investors are having to shift their assumptions abruptly. Both factors complicate the central bank's job, making it harder to curb inflation without tipping the economy into a recession.
It didn't have to be this way.
In the space of a few days since its most recent policy announcement, the Fed's signaling changed. On March 16, Chair Jerome Powell reassured financial markets that the recovery was at last ready to withstand a timid lift-off in interest rates — a first rise of 25 basis points, with more to follow, leading to a short-term rate of maybe 2% by the end of this year. Since then, in light of further bad news about inflation, officials have turned more hawkish, warning that future rate increases and moves to run down the central bank's holdings of debt would be bigger than advertised.
A different approach to monetary policy would have guided the Fed toward an earlier lift-off and helped investors to understand what was going on.
For many years, successive generations of macroeconomists — most prominently of late, David Beckworth and Scott Sumner of George Mason University — have urged the Fed, in devising and explaining its policy, to give a leading role to nominal gross domestic product (NGDP). The advantages are clear even under ordinary circumstances. In current conditions, with the economy hit by complex supply-side shocks, the case is even stronger.
NGDP, the money value of the economy's output, is a measure of aggregate demand and the variable the Fed acts on directly. Changes in monetary policy induce changes in NGDP — but the Fed can't control how much growth in NGDP is from higher real output and how much is from higher prices, the quantities it cares about. Using NGDP as an intermediate target to guide monetary policy recognizes this. Unlike the “dual mandate” of full employment and stable prices, it acknowledges the limits of what the Fed can do.
The Fed delayed raising interest rates until now because it wasn't sure why inflation had spiked and whether the pandemic-driven contraction of the labor force would reverse. An excess of demand over supply is driving prices up — but how much of this excess is due to high demand and how much to temporary interruptions in supply?
A central bank that watched NGDP can be agnostic about this. It would compare actual NGDP to its target, and aim to keep it growing on track. Changing supply conditions would then determine what happens to inflation and output.
If NGDP is kept on a rising trend of 4% a year, trend output growth of 2% would yield inflation at 2% — a plausible standard scenario. If supply shocks cut output by 2%, steady growth in NGDP would yield inflation of 6%, until the supply-side interruptions abated.
Maintaining trend growth in NGDP would give the economy sufficient demand to grow while keeping medium-term inflation in check. Crucially, it would relieve the Fed of having to take account of every deviation in output and inflation — something that, try as it might, it can't actually do.
The chart compares actual NGDP with a benchmark Beckworth calls “neutral NGDP” — a steadily rising level of demand consistent with medium-term growth and low average inflation, which is neither expansionary nor contractionary. Following the pandemic-induced shock in 2020, demand had recovered to this benchmark level by the second quarter of 2021. Had the Fed been watching, it would have seen a strong signal to start tightening no later than last summer — and would have been equipped with a simple explanation for lift-off.
Adopting an NGDP target doesn't solve every monetary-policy problem. The NGDP approach doesn't say how quickly to raise or lower interest rates once it indicates they need to change. It doesn't say whether the Fed should wait for NGDP to move off track or try to anticipate deviations. Exactly how is the benchmark trend to be calculated? Would it be better to target a growth rate for NGDP rather than a level? Should the method be enshrined as a formal rule or just used a guide alongside other criteria?
Regardless, it would be a big step forward if the Fed did no more than give NGDP a bigger role in developing and explaining its thinking. A simple, timely signal that policy needed to change would have been useful.
In current circumstances, one further benefit is worth noting. The NGDP approach implies that once demand is on track, any additional fiscal stimulus is surplus to macroeconomic requirements and will be automatically offset by monetary policy — a valuable check on governments tempted to treat fiscal expansion as a goal in its own right, rather than a way to help the Fed do its job.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Clive Crook is a Bloomberg Opinion columnist and member of the editorial board covering economics, finance and politics. A former chief Washington commentator for the Financial Times, he has been an editor for the Economist and the Atlantic.
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