I’ve done a number of posts advocated level targeting, but many readers remains skeptical. Here I’ll try to provide a bit more intuition in support of the idea.

Let’s think about a model with NGDP growth rate targeting at 4%/year. Assume that once every 5 years the central bank makes a mistake and NGDP moves 4% off target (i.e. 0% or 8% growth.) Then they let bygones be bygones and establish a new NGDP trend line from that point forward. Also assume that half of the errors are in an expansionary direction and half are in a contractionary direction. Thus once in every 10 years you get a recession, and once in every 10 years you get overheating and high inflation.

At first glance, it seems like switching to level targeting would be a step backwards. Now you’d see periods of declining NGDP occurring once every 5 years, not once every 10 years. This would occur when there was a contractionary mistake, and it would also occur when the Fed had to correct an expansionary mistake and get back to the old trend line. Twice as many recessions! That sounds bad.

I see two reasons why level targeting would actually produce better results than growth rate targeting. I’m going to focus on the issue of correcting overshoots, as many opponents of NGDP level targeting (including Jay Powell) have no problem with correcting undershoots.

[BTW, I am not suggesting we now correct the recent overshoot, because we don’t have a NGDPLT policy in place. I’ll explain the distinction later, but this is about setting up a new regime when the economy is currently in equilibrium, say back in 2019.]

I believe that NGDP growth targeting proponents overestimate the cost of correcting overshoots for two reasons:

1. They overlook the fact that level targeting would make overshoots (and undershoots) much smaller in the first place.

2. The overlook the fact that the pain of correcting NGDP overshoots from a booming economy is much smaller than the pain of an equivalent reduction in NGDP starting at trend.

Both of these conjectures require some explanation:

Suppose that in mid-2021, the Fed had announced that any overshoot of NGDP would be erased as quickly as possible, using a tight money policy to bring NGDP back to the trend line. In that case, as NGDP started heading for an overshoot in late 2021, interest rates (relative to the natural rate) would have soared much higher, in anticipation of a future tight money policy to bring NGDP back to trend. BTW, most of the contractionary “work” would have been done by lowering the natural interest rate, not raising the actual policy rate.

Instead, the Fed held their policy rate far below the natural rate in late 2021, causing NGDP to dramatically overshoot the pre-Covid trend line.

So yes, under level targeting there’d be twice as many periods of declining NGDP as under growth rate targeting, but they’d be correcting much smaller overshoots—say 1% or 2%, not 4% as with growth rate targeting. As an aside, many New Keynesian models suggest that changes in the current level of aggregate demand are heavily influenced by changes in future expected levels of aggregate demand. In these models, an expectation of future tightening makes money tighter right now. Thus under level targeting, the market helps to stabilize the economy. This may be one reason why New Keynesians such as Michael Woodford have advocated NGDPLT.

In addition, the corrections would be much less painful, even for any give reduction in NGDP. To see why, we need to consider the components of NGDP growth. Recall that NGDP is also gross domestic income. Overshoots of NGDP can be decomposed into overshoots of profits, hours worked, and nominal hourly wages.

When overshoots are corrected quickly, almost all of the action takes places with profits and hours worked. During the period of correction, the economy moves from excess profits and higher than nominal hours worked back to normal profits and normal hours worked. That’s not painful!

What would be painful? Suppose the excessive monetary stimulus were persistent. Eventually, those sticky nominal wages would begin rising. Output would return to the natural rate. In order to reverse these excessive wage gains, you’d probably need to create “slack” in the economy, i.e. higher unemployment. That doesn’t mean a softish landing is impossible, but it’s far more difficult than under level targeting.

The best time to correct the policy mistake is right away, before the NGDP overshoot spills over from profits and hours worked into higher nominal hourly wages. This sort of correction will be much less painful than a reduction in NGDP starting from trend, which would likely create a recession.

Some commenters ask me, “Given that you favor level targeting, what should the Fed do now?” To begin with, the Fed should only do NGDP level targeting if it has already announced a very specific NGDP level target. It has not done so, and hence it would now be inappropriate to return to the pre-2020 trend line. We don’t even know what trend line they would have chosen if (back in 2019) they had opted for NGDP level targeting.

So that’s all a moot point. If the Fed is targeting 2% inflation then they should target 2% inflation. I’m not happy with the target—I’d prefer NGDPLT—but if that’s the target then take it seriously. (Obviously the dual mandate allows some flexibility, but at a minimum the long run inflation rate needs to average 2%.)

Some people still fail to see that monetary policy was too expansionary during 2022. Admittedly, by that time it was too late to return to the old trend line, but we should at a minimum have reduced NGDP growth to the old trend line. Instead, the economy rose further and further above trend and the labor market continued to be wildly overheated. In 2022, we could have had a tighter monetary policy, lower inflation, and a better functioning labor market.

If I switch from eating three donuts every breakfast to two donuts every breakfast, that certainly doesn’t mean I’m dieting. Money was too expansionary in 2022, even if NGDP growth slowed late in the year. Growth was still far too rapid.

[BTW, the real consumption figures from 2022 are highly suspect, as they don’t account for the horrendous decline in the quality of service faced by consumers of things like travel and hotels. As we return to normal, the rate of productivity growth rate will be understated.]

PS. Here’s a shorter version of this post. Macroeconomic instability is caused by fluctuations in the growth rate of the aggregate nominal wage rate. Level targeting stabilizes nominal wages more effectively than growth rate targeting.

Once again, we are hearing calls for a more contractionary monetary policy in Japan. Here is a FT headline:

“Bank of Japan must respond to increasingly sticky inflation

Accommodative monetary policy stance no longer makes sense“

But when I look at nominal wages in Japan, I have trouble seeing any evidence of persistent inflation. (Inflation not associated with wage increases is transitory.)

I am open to arguments that I’ve missed something. Thoughts?

This Matt Yglesias tweet caught my eye:

That picture reminded me of a TV show called The Jetsons, which premiered in 1962. So where did the producers of The Jetsons get their ideas for the look of a futuristic city? Perhaps from this building at LAX, completed in 1961:

Or how about this building, completed in 1962:

Or this 1962 building:

Or this 1962 building:

What’s my point? When people envision the future, they look around at current things that seem futuristic. That’s no surprise. The futuristic buildings of 1962 looked nothing like the futuristic buildings of 1912 or 1862. That’s no surprise.

What is surprising is that a 2023 picture of a futuristic city still looks like a 1962 TV show. And like a bunch of cutting edge 1962 buildings

So what’s going on here? I suspect that progress has basically stopped at the macro level, and micro progress in areas like like biotech and computer chips doesn’t affect the way things look at the macro level. And I haven’t cherry picked the building industry; I could have shown you an airliner from 1962 and today and you’d be hard pressed to tell them apart.

I have no idea what cities will look like in 2123. Perhaps they will look futuristic. Maybe they will look much like current cities. But I can predict the look of sci-fi movies in 2123. Their futuristic cities will look like the Jetsons. Like 1962. The eternal modern.

PS. When I was young, we drove through Chicago once or twice a year, on the way to visit grandparents. I’ll never forget the look of the Marina Towers (above) which blew my mind. I had a plastic model of the Space Needle in my bedroom. The future seemed really bright.

Little did I know . . .

I recently heard a NPR discussion of the “long and variable lags” in monetary policy. Not surprisingly, it made me cringe.

They discussed the fact that Milton Friedman believed that monetary policy affected the economy with a lag as long as 18 months (but variable in length.) Then the host explained that “monetary policy” meant changes in interest rates. Friedman must be rolling over in his grave. He explicitly rejected the notion that interest rates were monetary policy and he did not believe that changes in interest rates affected the economy with a long lag. It would be more accurate to suggest that he believed the economy affected interest rates.

Unfortunately, Friedman’s preferred indicator (M2) is only modestly less bad than interest rates as an indicator of the stance of monetary policy. Consider the fact that M2 is up 34.8% in the past 3 1/2 years, and is down 3.7% in the past year. I occasionally see old-line monetarists claim that the big rise in M2 caused the inflation overshoot, and that the recent fall in M2 shows that money has now become too tight. Maybe, but I don’t see the logic of this claim.

Over the past 3 1/2 years, the PCE price index is up 14.9% and NGDP is up 23.6%. Both of these increases are far less than the rise in M2. So if you took monetarism seriously, you’d conclude that the 34.8% rise in M2 hasn’t yet worked its way though the system. We’re still waiting for those mysterious “long and variable lags”. Velocity was temporarily depressed by Covid and (the theory suggests) once it returns to normal we’ll see a lot more inflation. Instead, monetarists seem focused on the recent drop in M2. Why? Are the money supply figures since the beginning of 2020 meaningful? Or not?

To be clear, monetarists might be correct that money is currently too tight and we’ll soon enter a recession. I just don’t see how one would conclude that from the fact that M2 is up 34.8% over the past 3 1/2 years and NGDP is up only 23.6%.

Here’s how I see things. A change in monetary policy affects future expected NGDP (say one or two years out) almost instantaneously. Current NGDP immediately responds by a very small amount (higher commodity prices), and over a few months the effects become quite large. The scientific way to look at policy lags would be to create a deep and liquid NGDP futures market, and then look at how long it takes changes in future expected NGDP (i.e. “monetary policy”) to affect current and near term NGDP. I suspect the effect mostly occurs quite fast, within a few months.

The whole long and variable lags nonsense is an excuse to explain flaws in existing Keynesian models (which suggest monetary policy is changes in interest rates), and flaws in monetarist models (which suggest monetary policy is changes in M2.) Since both models are wrong, they need to explain their failed predictions in roughly the sort of way an astrologer explains his bad forecasts by being intentionally vague. Lots of mumbo jumbo about long and variable lags.

Future generations will be embarrassed by the pseudoscience that masquerades as “monetary theory” in the 2020s.

PS. Many economists seemed to believe the Fed adopted a “tight money” policy in 2022 and that we’d have a recession in the first half of 2023. How’d that prediction work out?

PPS. The “credit channel” people thought last March’s banking crisis would worsen the recession. How’d that prediction pan out?

PPPS. The Atlanta Fed nailed the RGDP forecast (2.4%).

Back in late 2008, I argued that tight money was driving the economy into a deep recession. One counterargument was that interest rates had declined over the past year. I pointed out that interest rates are a misleading indicator of the stance of monetary policy. The response would be something like, “Yes, nominal interest rates can be misleading, but surely real interest rates are indicative.”

Even real interest rates are unreliable, albeit less so than nominal rates. But here’s what’s interesting—real interest rates were soaring in late 2008, exactly when the Fed’s tight money policy drove the US into a deep slump. So why did almost all economists miss that fact? When I raised the issue, I was told that real interest rates are also misleading, due to various factors. I agree! But then how do we measure the stance of monetary policy? I prefer to look at NGDP growth (and levels.)

This tweet caught my eye:

Fortunately, Kathy Jones doesn’t make any claims about the stance of monetary policy. But you can be sure that lots of people will look at this graph and argue that the high real interest rates show that money is tight. So was money also tight in late 2008?

PS. Jones makes a minor error when suggesting that real rates are at the highest level since 2007. Actually, the spike you see (blue line) was in late 2008. But it’s an understandable error, as who would have imagined that the Fed would drive real interest rates up to 6% just as the US was sliding into a deep recession?

PPS. Q2 NGDP figures will be released in a few days. Let’s see what they show before concluding that money is tight.