The Lucas critique cuts both ways
I’m occasionaly asked how NGDP level targeting would have performed in a specific historical case, such as 1981 or 2023. The usual worry is that when NGDP is well above trend, a policy of level targeting might require a highly contractionary monetary policy, triggering a recession.
Here it’s worth recalling the Lucas critique (from Wikipedia):
The Lucas critique argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.
The problem with trying to evaluate how NGDPLT would have done in a specific case is that if the policy had been in effect during that period then the condition of the economy would have been much different. Thus if NGDPLT had been in effect during the 1970s, then it’s unlikely the economy would have become so overheated by 1981. Indeed the whole point of NGDPLT is to prevent the sort of inflationary policy we had during 1965-81.
If NGDPLT had been adopted last year, it’s unlikely that the Fed would have tried to push the economy back to the pre-2020 trend line, as that would have triggered a deep recession. They would have started from a new trend line. On the other hand, if NGDPLT had been adopted in 2020, then monetary policy would have been far tighter in 2021, and the economy never would have become so overheated.
The Lucas critique is often viewed as a cautionary tale—something that makes it likely that policy innovations will disappoint. In the case of NGDPLT, however, the Lucas critique suggests that the policy might be more effective than it appears at first glance. Instead of thinking about how NGDPLT would deal with all of the “shocks” we’ve experienced over time, think about how NGDPLT would have prevented those shocks from occurring in the first place.
Off topic: Conor Sen has a good piece on how the economy seems to be re-accelerating:
Slower inflation was supposed to be a sign that the economy was cooling, all part of the Federal Reserve’s plan for higher interest rates to restore balance to the economy. For a while, things looked on track. But since the middle of January there’s an argument that economic activity is picking up again, despite monetary policy being tighter than at any point in years. . . .
Frequent readers of mine will note that this is a walk-back of a bias I’ve had for the past few months. I started worrying about a labor-market slump in early November as the unemployment rate rose and worker income growth slowed. Earlier this month, I described the recovery in some cyclical parts of the economy as akin to a “dead cat bounce” that would eventually be swamped by high interest rates; it’s not unreasonable for something like existing home sales to climb when transactions were at their lowest level since 2010.
Frequent readers know what I’m about to say. At no time in the past few years has monetary policy been “tight”. Indeed it’s been generally expansionary, which is why NGDP growth remains excessive.