The Fed can fight inflation and unemployment — Here’s how
By now, anyone who has been following the financial news understands that the Federal Reserve faces a steep challenge: to achieve a “soft landing” that reduces inflation without spiking unemployment and causing a recession. Engineering this landing has historically proven difficult, especially in cases like today’s where inflation and nominal GDP (NGDP, or total spending in the economy) growth are both very high. International shocks like the COVID-19 pandemic and the Russia-Ukraine war have also contributed to rising prices, making it difficult to distinguish the causes of inflation.
Although it’s unclear if the Fed can actually pull off a soft landing, it can take a big step toward avoiding — or at least mitigating — a recession by promising to bring one specific measure — NGDP growth — back to its pre-pandemic trend.
As you may remember from economics class, NGDP growth is the sum of economic growth (in terms of real GDP) plus inflation. In 2021, real GDP growth was 5.7 percent and inflation was 6.1 percent, making NGDP growth 11.8 percent. This was much higher than the pre-pandemic trend of roughly 4 percent growth. While higher real GDP growth suggests higher living standards, excessively high NGDP growth is a recipe for persistent inflation.
NGDP targeting has at least two big advantages over the Fed’s current approach which are particularly well-suited for today’s situation:
First, under an NGDP target, the Fed would not have to worry about inflation from supply shocks, which increase or decrease the supply of goods and cause prices to change. If a central bank misreads a supply shock for a more serious inflation problem and then tightens monetary policy to slow the economy, it can end up exacerbating economic pain.
This is exactly what the Fed did in 2008 when high oil and commodity prices caused it to worry about inflation when the real problem was a slowing economy. First, the Fed signaled plans to raise its benchmark interest rate, the federal funds rate, and then it failed to sufficiently cut the rate even as a financial crisis intensified.
By contrast, a nominal GDP-targeting central bank only tightens policy if NGDP grows above trend. Thus, it can more easily discern between inflation it should respond to and price shocks it should ignore.
Second, NGDP targeting allows the Fed to simplify its goals. The Fed has a congressional mandate to produce price stability (low inflation) and maximum employment. By simply targeting NGDP instead, the Fed could indirectly stabilize both variables. It hits two birds with one stone.
To understand why, we need to recognize that while monetary policy determines “nominal” variables like inflation and NGDP, it only temporarily affects employment. Employment is ultimately a “real” variable determined by non-monetary factors like workers’ education and skills.
In the 1970s, the Fed pursued a policy to achieve low unemployment until it determined inflation had become too high. But because monetary policy cannot affect long-run employment, this policy only led to high inflation.
Today, the Fed is in a similar bind, though not as acute. If it sees unemployment rising, it may be tempted to stop tightening policy even if inflation is still well above trend. NGDP targeting offers a way out.
If unemployment rises and NGDP growth falls below target, the Fed would know it’s time to ease monetary policy and let the economy catch up. By contrast, if unemployment edges up but NGDP growth is still above target, the central bank should continue to tighten policy. Although NGDP targeting allows inflation to fluctuate modestly in response to business cycle conditions, the public can be confident about the average inflation rate over the long run. That also means the Fed can embrace NGDP targeting while remaining committed to its goal of 2 percent inflation over time.
Critics of NGDP targeting note that this data only comes out quarterly, while inflation data comes out monthly. To overcome this challenge, the Mercatus Center at George Mason University has a new monthly forecast of the “NGDP Gap” — the percentage difference between a “neutral” level of NGDP that is neither inflationary nor deflationary and actual NGDP.
Currently, the gap is expected to grow for the next two quarters before gradually falling, suggesting that monetary policy is still not tight enough. As my colleague, David Beckworth, and I show in a recent study, this measure would have forecasted both a slowing economy in 2008 and the 2021-22 inflation surge.
High inflation today is the result of the Fed’s past mistakes as well as factors beyond its control. Regardless of whether the United States avoids a recession, NGDP targeting offers a practical way to minimize the pain from both inflation and unemployment.
Patrick Horan is a research fellow with the Mercatus Center at George Mason University.
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