in other postsI argued that two factors contributed to monetary policy mistakes.
1. The goal is wrong.
2. You have an equipment setup that is unlikely to reach your goals.
In the comments section, John said: next claim:
I think this is a good and correct post to respond to Tyler, but it raises a conundrum. Your argument is basically that policymakers should not rely on inflation forecast models and instead rely on market-based expectations about inflation (or nominal GDP). But how should market participants forecast inflation (or nominal GDP)? I don’t think nominal GDP is high (perhaps if the Fed actually had a goal of targeting NGDP) because it would be satisfactory for this purpose to have nominal GDP high.
I think the case “nominal GDP is high because the Fed set nominal GDP high” is a useful way to understand the problem, even if it is not a complete explanation in the deepest sense of the term.
Consider the following analogy. Fred is depressed. One day while driving down the road, he decides to speed up his car and crash 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 the 12 o’clock position on the steering wheel to the 3 o’clock position on the steering wheel, causing the car to suddenly swerve toward a large tree.
The second explanation feels more scientific and similar to ‘physics’. However, most people find the first explanation more useful.
Insiders suggest that the Fed fully understands that NGDP will be well above trend by the end of 2021. The same perception was widespread outside the Federal Reserve. So why did the Fed make this mistake? at Recent CommentsRajat reminds me of a conversation between David Beckworth and Jason Furman that occurred in mid-2021. Here are Rajat’s comments:
Since I started reading your blog in 2011, it’s taken me at least two years to grasp the importance of level targeting to your approach. The NGDP aspect is what made you stand out. Perhaps because it was too intuitive in the midst of a supply shock. But in (my) hindsight it matters less. I think the reason policymakers and people like Tyler have a hard time accepting level targeting is because it removes a major policy escape valve. I continue to listen to David Beckworth’s interview with Jason Furman on Macro Musings (from June 2021). Here Furman said:
“In 2019, you set out a very elegant framework for nominal GDP targeting. If we were following along now, we would have already cut interest rates. And we are likely to exceed the nominal GDP target we have set by a very high level.
Therefore, your framework should compensate for this with continued periods of lower than trend nominal GDP growth. I don’t mean to criticize you. This experience destroyed everyone’s plans that they had previously written down. These are really strange times. But to me it says: “If the unemployment rate is still at 5.5% a year from now, I wish the Fed would take that into account regardless of what’s happening to nominal GDP or prices. “It’s an independent issue and issue for them to consider.” So I think everything should have a double duty, look at nominal GDP instead of inflation, etc.? maybe.”
As it turns out, had the Fed tightened in the first half of 2021, the United States probably could have avoided much of the excess price level rise it has experienced with little reduction in employment growth. But as you point out, in the US the supply shock has largely been reversed. What if that doesn’t happen and the Fed tightens in the first half of 2021 anyway? If so, employment would 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, a brilliant economist. But in this particular case he was wrong. Policies needed to be strengthened to prevent large NGDP overshoots. The Fed knew what they were doing. Despite clear signs of NGDP growth trending above, interest rates were set at zero and extensive quantitative easing was implemented. Going back to the two types of mistakes described at the top of this post, the late 2021 errors were clearly an example of “wrong goals.”
Looking more broadly, almost all important These are the types of policy mistakes the Fed makes. Commentators sometimes point out that the inflation spike in 2021-23 ended up being much larger than the TIPS market expected in early 2021. That is true, but this fact is not what many people assume. This doesn’t mean the Fed did the best it could and was just unlucky. under level targeting system The inflation spike would have been much milder, with temporary supply-side inflation but no permanent NGDP overshoot. The main reason for the high inflation over the past five years has been NGDP exceeding the 4% trend line by 11% per annum. There are so many!
If I were to weight my policy advice in terms of relative importance:
10% weight on using markets to guide policy. (tactics)
90% weighting is applied to performing NGDP level targeting. (strategy)
Being a skilled navigator won’t help you much if you’re not aiming at the right target. Market guidance is useful, but it is not a panacea.
