Evan Koenig on the Case for Nominal GDP Targeting

Evan Koenig is a former senior aide to the president of the Dallas Fed. Evan returns to the show to discuss, the ins and outs of nominal GDP targeting, the practical applications of NGDP targeting, the reasons the Fed should consider it for the framework review, and much more.

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Read the full episode transcript:

This episode was recorded on October 29th, 2024

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Hey Macro Musings listeners, this is your host, David Beckworth. As you know we are in the midst of another Fed framework review. We have already released several podcasts and our very special policy brief series on this important development. This week’s episode is another one that speaks to the Fed’s framework review, it is with Evan Koenig a former senior aide to the president of the Dallas Fed. We recorded this show in late October of last year, but its material is very timely to the current and ongoing framework review process. We hope you enjoy it, now on to the show!

Welcome to Macro Musings, where each week we pull back the curtain and take a closer look at the most important macroeconomic issues of the past, present, and future. I am your host, David Beckworth, a senior research fellow with the Mercatus Center at George Mason University. I’m glad you decided to join us.

Welcome, Evan Koenig. Why don’t you tell the listeners a little bit about your background at the Fed?

Evan Koenig at the Fed

Evan Koening: Okay, sure. My entire career at the Federal Reserve was with the Federal Reserve Bank of Dallas. I joined the Dallas Fed in the late 1980s and continued to serve there until a few years ago. I was appointed senior vice president and principal policy adviser by Richard Fisher and then continued in that role under President Rob Kaplan until Marc Giannoni came on board as director of research.

In that role I had the responsibility of briefing the bank president on macroeconomic conditions, making recommendations on monetary policy, and typically accompanying him to Washington, DC for FOMC meetings. That was a real treat. Boy, it never got boring for me. It was always exciting to sit around that table and listen to the discussion.

Nominal GDP Targeting

Beckworth: Evan, let’s talk about nominal GDP targeting. Let me start with my first question. What is nominal GDP targeting, and how did you get interested in it?

Koenig: As far as what nominal GDP targeting is, it’s much as it sounds like. You set in advance a target level for some measure of nominal spending. It might be nominal GDP, it might be nominal gross domestic income, personal consumption expenditures, some measure of gross nominal spending or income. Equivalently, you can set a target growth rate for a nominal income aggregate over some period of time: X quarters or X years.

The issues, some issues involved with this approach are what spending aggregate or what income aggregate are you going to target? Over what time horizon are you going to target it? How far in advance do you specify your target? In some theoretical analyses, it’s actually instead of an equal weighting on price and output, which is what you have when you have nominal spending or nominal income of some kind, you might take a weighted average of those two things. Theoretically, that’s superior in some contexts, but you sacrifice a lot of simplicity. Your communications aren’t as clear if you do something more sophisticated like that.

Beckworth: Evan, how did you get interested in nominal GDP targeting? It’s not a very widely known or popular view.

Koenig: This goes all the way back to the late 1980s when I first joined the Federal Reserve Bank of Dallas. At that point, there was increasing interest among central banks around the world in something called inflation targeting. A new colleague of mine, Mark Wynne, who is still at the Dallas Fed, and I got into a discussion about what is this thing called inflation targeting and why would one want to move in that direction, focused more on the inflation side than on the output side.

He brought up the argument of Irving Fisher from the 1930s where the idea is that the US economy would have performed so much better if the Fed had had a price level target during the 1930s. I had recently purchased a house. I had a big mortgage payment each month. I may have had a car payment as well.

I thought about this and I thought, well, gee whiz, what’s important to me is my flow of nominal income. If I’ve got these fixed nominal obligations, what I care about is my nominal income. It doesn’t matter whether my nominal income drops because the price level has fallen or because my hours of work have been cut. Both of those things matter in the same way to me and they only matter to me through the flow of income that I’m receiving.

It took me 20 years to formalize that intuitive argument. It wasn’t as if I was working on it all that time but, 20 years later I started thinking about it. Steve, there’s got to be a way to formalize this and make it explicit. I ended up with an article in the International Journal of Central Banking that made basically the argument formally that I just gave you informally about the virtues of having a predictable path for nominal income. That’s how I got into it.

Beckworth: That’s a great story. Now back in 2019-2020 we had the first framework review where the Fed looked at its inflation target. Back then it was the flexible inflation target or FIT. Then they eventually went to the flexible average inflation targeting or FAIT, so from FIT to FAIT. At that time there was not much consideration given to nominal GDP targeting as a potential framework. Why do you think that is?

Why the Fed Didn’t Consider Nominal GDP Targeting

Koenig: Just in general, that strategy review was very narrow. It was narrow in a number of respects. It was narrow in the sorts of shocks that it considered. Its focus was on negative shocks to aggregate demand, particularly in a situation where short-term interest rates might be up against the effective lower bound, as the Fed likes to talk about it. I still talk about it as the zero lower bound.

That was a narrow focus on a particular kind of shock in a particular situation. It was narrow in that sense. It was narrow in the modeling framework that was employed. All of the analysis was done in terms of a representative agent economy with Calvo-style sticky prices. You have staggered price setting. Firms set prices only periodically on occasion. It’s a random interval between price changes, and different firms set their prices at different times.

That’s sort of the workhorse model in macroeconomics, particularly in universities. That’s not the only kind of nominal friction that’s out there. There is also such a thing as wage stickiness, not just price stickiness. As we just talked about, there’s such a thing as having fixed nominal obligations, repayment obligations for debt. Those sorts of nominal frictions were not included in the models used in that strategy review.

It was a narrow focus in terms of the type of shocks hitting the economy, a narrow focus in terms of the nominal frictions which were built into the economy that was used to come up with a strategy. I think there was a hesitancy on the part of many to acknowledge the role that the FOMC plays or the role that the FOMC strategy choice plays in financial stability.

Historically, at the Fed, the approach to financial stability has been through financial regulation, focusing mostly before the financial crisis on individual institutions, financial institutions, and then after the financial crisis more broadly on the financial system as a whole. Historically, the approach to promote financial stability has been through financial regulation. That’s under the control, the supervision of the Board of Governors, not the FOMC.

There’s this governance understanding that the FOMC isn’t going to worry about that aspect of monetary policy, that the Board of Governors is going to worry about that and they’re going to approach it through financial regulation. That was a narrowness that was built in to the strategy review.

As I suggested in our initial discussion, much of the argument for a nominal GDP target, at least in the framework that I used, was a financial stability consideration. The financial trouble that households can get into if their financial obligations are fixed in nominal terms, but then their income drops, it really puts them in a bind. That can spill over into problems for financial institutions. If enough households are delinquent on their debt or default on their debt, that starts to affect the entire financial system.

That was treated as out of bounds, not the FOMC’s concern. Then there was, just in general, and I don’t think this appears in any written document, but it came across in personal communications I had, that nominal GDP targeting was just too weird. That’s the one that bothered me the most. Weird in a couple of senses: that it was somehow in conflict with the Federal Reserve Act, that the Federal Reserve Act specified these two goals—price stability and full employment—and they needed to be kept separate because they were listed separately in the Federal Reserve Act.

I’m not sure that I got that right, but it never made a whole lot of sense to me. Because if you look at the Federal Reserve Act, what does it call for? I’m going to refer to my notes here because I don’t have it memorized. The Federal Reserve Act calls for the Fed to maintain growth in dollar liquidity, and they specifically refer to money and credit aggregates. Those are just examples of measures of dollar liquidity in the economy. Here’s a quote: “commensurate with the economy’s long-run potential to increase production so as to promote the goals of maximum employment, stable prices, and moderate long-term interest rates.” What is nominal GDP but a broad measure of liquidity, dollar liquidity in the economy?

It seems to me that it would have made sense for the FOMC to at least consider doing what the Federal Reserve Act suggests, which is picking a growth rate for this broad measure of nominal liquidity commensurate with the economy’s real growth potential so as to promote the goals of price stability and full employment and moderate long-term interest rates. It seems to me instead, it’s not in conflict with the Federal Reserve Act; it’s very much congruent with the Federal Reserve Act to take this approach.

That was one criticism of nominal GDP targeting that never made a whole lot of sense to me. The other thing was that there was also this argument that it was too different from the way the Federal Reserve had been conducting monetary policy and that change might be confusing. That never made a whole lot of sense to me either because as I pointed out in a staff paper I wrote, I think in 2012, for the Federal Reserve Bank of Dallas, you could actually implement nominal GDP targeting with something that looks very, very much like a Taylor Rule where you’ve got a gap between an inflation rate and a target inflation rate and you’ve got a gap between output and some measure of potential output and you either have a tight policy or a loose policy, depending upon whether the sum of those two gaps is positive or negative.

A Taylor Rule is something that’s very familiar to monetary policy practitioners, to macroeconomists. To implement nominal GDP targeting, it wouldn’t be a big step at all to just relax the Taylor Rule slightly in a couple of respects and use it to implement a nominal GDP target. 

I’m not sure that’s the way to communicate nominal GDP targeting to the general public. I think it’s so much more intuitive to talk about we’re trying to ensure that the economy as a whole has this predictable path of income coming in because we understand that you have these fixed nominal obligations you have to worry about. That seems to be very intuitive to people and you can communicate how well you’re doing by having a plot of the path of nominal GDP and comparing it to the path you’re trying to get to. If you want to build something into your macro model to try to predict the future behavior or model the future behavior of the Federal Reserve you can do it with a Taylor Rule.

It doesn’t seem to me that nominal GDP targeting is weird in that sense either. Those are the reasons I think nominal GDP targeting didn’t get a whole lot of attention in the last strategy review. Some of the charges against it are bogus and some of them it was just a very narrow focus on a particular type of shock on a particular type of model and this governance thing where somehow FOMC policy supposedly has negligible implications for financial stability.

Beckworth: Now, to be fair, there was one paper that did briefly mention nominal GDP targeting, if I remember correctly, maybe more, but it was a paper at the Chicago conference. I wasn’t there but I heard the stories. You were there. Lars Svensson talked about his preferred approach was flexible inflation targeting in some form. He briefly mentioned it, nominal GDP targeting. He’s very critical of it. What I understand is that you, Jim Bullard, maybe a few other people got up and quickly responded to his criticisms. Maybe tell us about that interchange and what Lars got wrong.

Koenig: I think this goes back to the discussion we just had. My comment was on the nominal friction that was built into Lars’s model and it was only one. It was Calvo-style, staggered price setting. I said, “Well, of course, if that’s your only friction.” We know what optimal and monetary policy looks like. The only twist is how are you going to handle the zero lower bound. I just pointed out, well, there are these other nominal frictions too. I pointed specifically to the nominal debt obligations, and said you get a completely different result if that’s your nominal friction.

Another—I don’t remember who this was—but one of the other people who offered a comment pointed out that under nominal wage stickiness, you get a different result. Something like nominal and GDP targeting looks to be the best approach. That’s something I had pointed out in a paper I wrote in Economics Letters, I think in 1996 or something like that. 

I used a simple optimizing model and the only friction in it was that wages were set in advance. What kind of monetary policy do you want? Depending upon whether you  had government purchases in the model economy or not, it was either something very much like nominal and GDP targeting or you looked at a weighted average of nominal consumption and nominal GDP and targeted that. Those were the criticisms.

Jim Bullard spoke up in defense of nominal and GDP targeting too. He had done some work with overlapping generations models and nominal GDP targeting and was a big advocate. I appreciate him shining that.

How to Explain Nominal GDP Targeting to the Public

Beckworth: He shares your view. He also argues that it stabilizes the financial system if you can stabilize those nominal income flows. Evan, the one time I’ve had a conversation with Jay Powell alone, just the two of us, we got into this question of nominal GDP targeting and how do you sell it? How do you market it to the public? He thought it was really challenging. I think the point you made is very compelling. In some ways, it’s much easier to sell to the public, “Hey, we’re trying to stabilize overall incomes.”

Do you think that’s easier for people to understand than we’re trying to stabilize prices? Because even when we talk about stabilizing inflation or prices, people get confused by the gas prices they face, relative prices versus the overall price level. Would any of that confusion arise with nominal GDP targeting or nominal income targeting or would it be more intuitive, easier to not have confusion arise from relative versus overall nominal income growth?

Koenig: I think, especially after the last strategy review, I’m not surprised that people are confused. There is this, what inflation do you respond to? Well, we’re not going to respond to perspective increases in inflation, but we are going to respond—in fact, forcefully—to perspective decreases in inflation. What inflation matters? Well, we’re not going to pay attention, even if realized inflation goes up, if we think it’s transitory. That we don’t respond to. We are going to respond to declines in inflation, even if they’re transitory.

Some of the language that’s used, how do you describe your policy? Chair Powell, in a recent press conference: “My colleagues and I remain squarely focused on achieving our dual mandate goals of maximum employment and stable prices.” Okay, what’s the plan? How are you going to achieve those goals? It’s left unspecified.

The Fed has this statement of “On Longer-Run Goals and Monetary Policy Strategy.” The first paragraph of that statement is just perfect: “The committee seeks to explain its monetary policy decisions to the public as clearly as possible. Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.” Perfect, exactly right.

Then with all that discussion of how important clarity is, how much effort has gone in to try to explain the new strategic framework and how imperfectly people still understand it. They’re just at loggerheads with each other. What if the price stability and full employment goals conflict with one another? What do you do then? The Fed says, “Well, we have to take them both in account and we weigh them off against each other.” As far as how you weigh them off against each other, the public is left to guess or to rely on speeches by Federal Reserve officials.

There’s a promise to run inflation moderately above 2% for a time if inflation has fallen short of 2%. Well, what is moderately? What is for a time? All of that unspecified. How is it that we’re going to have 2% average inflation over the long term if we try to offset shortfalls, but we don’t offset overshoots of inflation? If you’ve been responding asymmetrically to shortfalls and overshoots, how can it average out to what your target is?

That’s confusing, I think, too. It’s confusing to me. I assume that it’s confusing to the general public, too, if they even bother to try to understand it. I think that something like a nominal GDP target, it’s very intuitive to people, again, just introspection. What happens to me if my income is suddenly cut by 10% or 25%?

Certainly, other people are in the same sort of situation I’m in, so it makes sense for the Federal Reserve to try to keep, at least in the aggregate—the Federal Reserve’s powers are limited. We can only look at aggregates if the Federal Reserve can keep aggregate nominal income on a predictable path that, at least on average, makes financial planning so much easier for households.

Again, it’s something that you just look at a plot of nominal GDP relative to the target path, and you can say, “Oh, we’ve fallen behind here. We need to provide more stimulus to get us back up to that target path.” Or, “Oops, we’ve overshot. We need to apply the brakes here.” Or, “Eventually, maybe not right away, but eventually we’re heading for trouble. We’re going to end up with higher inflation than we want.” It just takes one graph to communicate a whole lot of information to people that they can understand.

Main Arguments for Nominal GDP Targeting

Beckworth: That’s great, and that gets us into the next question I wanted to ask you, and what are the main arguments for nominal GDP targeting? What you’ve just outlined, I believe, is the first one, and that is simplicity. It’s really simple, straightforward. It’s, in some cases, more intuitive, more obvious. In 2010, I believe, Bernanke went before Congress, said, “We want to raise the inflation rate,” and Congress about flipped. “You want to raise the inflation rate? We have a weak recovery.”

What he really meant is we want to raise nominal incomes. We want to raise aggregate demand. A higher inflation rate might be a symptom of that. The simplicity, the ability to communicate, something that people intuitively understand, I think that’s a great selling point, the first one. Let’s go back to the other point that you’ve raised, though. It fosters financial stability. You’ve noted how it does so on the downside.

If there’s a recession or some weakening, if the Fed can guarantee that your nominal income flow is going to be stable, you can still make your car payment, your house payment, your nominal fixed price debt contracts won’t be broken, you won’t go into default. What about the upside? How would it be useful for stabilizing financial conditions, let’s say, if there’s a big productivity surge, unexpected growth surge? Can it also serve that purpose in that environment?

Koenig: I think it provides financial markets with something of a reality check. If you just focus on inflation realizations, and you do get a productivity surge, inflation is going to dip. Unless that’s a permanent increase in the growth rate of productivity, it’s a temporary dip in inflation. If you stabilize inflation, what you’re going to get is a surge in nominal spending. Along with that, you’re going to see a surge in corporate earnings, a surge in consequence, and potentially in stock prices.

Asset prices more generally, if people get the perception that nominal income is going to be growing permanently at a faster rate, there’s a tendency to incorporate that into your earnings projections. If you’re a homeowner, possibly into your home price, what you think your home price is going to be doing over time. If the Fed looks at that surge, tries to stifle that surge in nominal spending growth and nominal income growth, or says, “Oh, we’ve overshot, this is not something that’s sustainable over the long term. We’re going to try to get back to our target path.” I think that tends to put the kibosh on these unrealistic earnings projections that financial markets might have. Yes, I think on the upside, it can serve as reality check and constrain or restrain irrational exuberance that might otherwise develop.

Beckworth: Okay, so we have simplicity, we have financial stability. What about the older argument for nominal GDP targeting? It’s a way for the central bank to deal with supply shocks.

Koenig: In the formal model that I’ve looked at in my International Journal of Central Banking piece, there were no price rigidities at all. It was a market-clearing economy. The only shocks in there were supply shocks. There were exogenous changes in output. Nominal GDP targeting prescribes trying to eliminate demand shocks because demand shocks tend to move price and output in the same direction. That would violate your nominal GDP target. It squashes demand shocks. What you’re left with is exactly supply shocks.

The point is that supply shocks can be damaging to the economy; even though they may not take you away from full employment, they could damage your financial system. Through that channel, if the damage to the financial system is sufficiently great, well, then you do get a demand shock. If your financial system implodes, you’re not going to have investment, you’re not going to have people able to smooth consumption through time, and you’re likely to see demand shrink. I think that there’ve been a couple of authors, Mark Gertler is one, I think Ben Bernanke have done sort of retrospectives on the Global Financial Crisis. 

They argue, I think pretty persuasively, that the first-round effects of the housing collapse on households, though those were bad, the main damage was caused by the second-round effects. The spillovers from the financial troubles that households got into, the spillovers from that to the financial institutions. Then once financial institutions were damaged, then that was just a multiplier of the damage to the economy and made it much, much worse. When all was said and done, the second-round effects were more important than the first-round effects. Of course, you wouldn’t have had the second-round effects if you hadn’t had the first-round effects. That’s where nominal GDP targeting helps you out.

That’s why the last strategy review, we talked about how they focused narrowly on demand shocks. Well, it’s in responding to supply shocks that I think nominal GDP targeting is particularly useful. What it also does, because it helps stabilize the financial system, is prevents those second-round demand effects from kicking in.

In summary, there’s a trifecta of benefits from nominal GDP targeting. You get enhanced financial stability from a more predictable path of nominal income for people who have fixed nominal obligations. Nominal GDP targeting actually promotes price stability by better anchoring. If you use a Taylor Rule approach, it actually gives you a better anchor for medium-term average inflation than inflation targeting does.

Inflation targeting just ensures that people expect inflation to approach 2% over the medium term. Nominal GDP level targeting, actually anchors what people expect inflation to average over the medium term, which is a stronger anchoring of inflation. Insofar as you have wage frictions, wage stickiness in the economy, nominal GDP targeting is going to promote full employment because it allows the price level some flexibility to move in response to productivity shocks in exactly the way it ought to move in order to get the real wage to its market-clearing level. That’s a third advantage. 

On top of all of those benefits, there’s this bonus that if you ever are in a zero lower bound condition, it provides forward guidance on policy. Embedded in it is a promise to make up for near-term shortfalls with future accommodation so that nominal income, nominal GDP gets back on the track that you set. If I had a generalization of trifecta to four things, I just don’t know what that would be.

Beckworth: Trifecta plus one, okay. Those are all great, compelling reasons in my view. Of course, listeners will know, I’m a big champion of nominal GDP targeting myself. Just to go back with my intellectual history on this, I understood many of those, but I really did not appreciate the financial stability one until I met you and then Jim Bullard, your work together, I guess, throw Kevin Sheedy in there as well, but you guys really pushed and developed, I think this financial stability argument.

To me, it resonated really well because coming out of the Great Financial Crisis, there were a lot of people calling for state-contingent debt contracts, so ones that would change based on the state of the economy. Really what nominal GDP targeting does is it gets you there without actually having to explicitly have a state-contingent contract. Because as you just said a few minutes ago, if nominal GDP targeting is implemented perfectly, there are no demand shocks, purely supply shocks that’s driving any recession or boom.

That makes inflation countercyclical. If you have a negative supply shock, real GDP goes down, inflation goes up. A positive supply shock is the opposite: Real GDP goes up, inflation down. You have countercyclical inflation, which in turn makes pro-cyclical real debt burdens. During a recession, the real debt burden goes down, debtors have less of a burden to bear; basically, creditors are bearing some of that risk. The flip side is during a boom, debtors are paying more, but that allows creditors to tap into some of that windfall gain that they didn’t anticipate.

You’re creating better risk-sharing, and more succinctly, you’re turning these fixed nominal debt contracts into something more like equity. It’s better risk-sharing going back and forth, and it gets you to the same place as if you had adopted state-contingent debt contracts from the get-go, which do not seem very popular. But you can get there with nominal GDP targeting adopted by monetary policy.

Koenig: I think that’s exactly right. The mistake that Irving Fisher and a bunch of other economists made, I think, is they recognized that there were these nominal debt contracts out there that were not contingent on the price level. How do you handle that? We’ll eliminate variation in the price level, and then the fact that they’re not contingent on the price level takes care of the problem.

Ignoring the fact that people get in financial trouble, not just if the price level—there’s this other contingency on real output that fixing the price level does not handle, but nominal GDP targeting does. It does exactly what you say, that when times are good, people’s real debt burdens rise. When times are bad, people’s real debt burdens are reduced. That’s exactly what you want to have. That’s what people would choose to have. If making contingent debt contracts was costless, that’s the sort of debt contract you would see.

Practical Applications of Nominal GDP

Beckworth: Another way of saying that is it’s a way to deal with the fact that we have incomplete financial markets. We can mimic that outcome without actually having them in the first place. Well, that’s great stuff on nominal GDP targeting. 

Let’s move to some practical uses or ways of thinking about them. Can you give me some examples of how you would monitor nominal GDP or some measure of aggregate spending? Then how would have this been helpful in some past experiences where we had some stress in the economy?

Koenig: Yes, so a couple of examples. Even though I’m retired, I still occasionally get phone calls from reporters before FOMC meetings in the blackout period when Fed officials can’t talk. I rely on nominal GDP personally to gain an understanding of what’s going on in the economy and whether monetary policy is easy or tight and what the situation is. I’ll come back to that.

Right now, I think another example which addresses the question you raised is an article I wrote along with Tyler Atkinson and Ezra Max. This was a Dallas Fed Economics blog piece that came out in January of 2022, but we wrote it in the fall or, yes, the late fall of 2021, where the latest GDP data were for the third quarter of 2021. The reason we wrote it was because if you looked at an extrapolation of nominal GDP growth from before the COVID crisis, given the Fed’s 2% inflation target, given that most estimates of long-run potential growth in the economy at the time were 2%, and given that the economy before COVID was roughly at full employment, the natural target path for nominal GDP would have been a 4% growth path extended out from late 2019.

We did that; we extrapolated a 4% growth path out, and we plotted nominal GDP since the beginning of the COVID recession. As it happened, in the third quarter of 2021, we just got back to that hypothetical target path, which is great. That’s what you want to do. The problem was that if you looked at the projections of private forecasters, and though we couldn’t talk about it at the time, if you looked at internal Fed projections, the projection was that nominal GDP was going to overshoot, substantially overshoot, that path and not come back to it.

Our argument was, “hey, great so far, but trouble ahead unless the Fed starts removing accommodation. We should be in a neutral policy stance now, neutral in the sense of stabilized nominal GDP growth at 4%. The recovery in nominal GDP has been completed. We should be at neutral, and we’re not at neutral. We’ve got our foot all the way down to the floor on the accelerator pedal, interest rates at zero, and we’re doing asset purchases.”

Well, as it happened in the November 2021 FOMC meeting, they decided to reduce the pace of asset purchases slightly. Maybe they eased up on the accelerator pedal by a fraction of an inch, but that was it. Policy was still clearly extraordinarily accommodative, and we were arguing that that was not the appropriate policy stance in the circumstances. If you want to look at this—this is January 13, 2022—Dallas Fed Economics blog posting, which is still available in the archive on the Dallas Fed. It’s a real-time application of nominal GDP targeting to analyzing the situation the Federal Reserve and the US economy were in, in late 2021.

Of course, the FOMC sat on its hands as far as interest rates were concerned until March of 2022. It took them, even though they moved with unusual quickness, it still took them quite a while to get the funds rate into restrictive territory because it had started in such accommodative territory. That same blog piece compares the experience in the COVID crisis to the Global Financial Crisis. They are the same plot.

You look at what people estimated potential GDP growth to be back before the Global Financial Crisis, added in 2% target inflation, start at a point where the economy was by most accounts at full employment, extrapolate that forward, and say, “Okay, so there’s your target path consistent with long-term price stability.” What happened to actual nominal GDP? Well, in that case, instead of rebounding and moving back toward that path, instead of moving toward it, you actually move further and further away from it over a time.

Clear message there. And this is the sort of graph that you could present to the public or to congressional committees. Clear message there is that for all that we’re doing, driving interest rates down to zero, purchasing assets, we’re falling further and further behind where we want to be. Then we looked at not just aggregate nominal GDP, we looked at the composition, what was happening to corporate earnings, what was happening to state and local government revenues, and what was happening to household disposable income in these two recessions.

In the Global Financial Crisis, no surprise. There were big drops relative to trend in these incomes, for these income flows for these different actors in the economy. Whereas in the COVID situation, for state and local governments and corporations, you actually were rising above trend. They were being made more than whole as a result of both Fed actions and the fiscal actions that took place.

You look at what happens in the measures of financial stress. We looked at bankruptcies, business bankruptcies, and nonbusiness bankruptcies in these two recessions. There again, you see big increases in bankruptcies, corporate and noncorporate, after the Global Financial Crisis. Whereas with COVID, you did not see those increases occur.

Much better financial stability results when you’ve stabilized nominal GDP than when you didn’t. There’s an example that was written in real time using nominal GDP to analyze where the economy was and where monetary policy was. I take basically the same approach when I’m called up by reporters these days. I look at different measures of nominal spending. I look at nominal GDP. I look at nominal gross domestic income. I look at the average of those two things because they’re supposed to measure the same thing and have the same answer. Often, particularly in the near term, they don’t. Averaging can be helpful.

I look at nominal PCE expenditures too. That tends to be more volatile, more up to date because it’s monthly, but more volatile. Unfortunately, right now, we only have data through the second quarter of 2024 for GDP and gross domestic income.

Later this week, we’re going to get another, I guess it’s tomorrow, we get another quarter’s worth of data. What’s interesting there is that if you compare growth in the first half of 2024 to the growth we saw in 2023, there’s no deceleration. Nominal spending continues to rise so far in 2024, the same rate it was rising in 2023, which suggests to me, at least, that if you’re trying to be restrictive, you’re not having much luck being restrictive.

On top of that, the growth rate that you’re seeing is in excess of 5%, which means if you believe the economy’s long-term real growth potential is 2%, over the long term, if you continue to have these sorts of growth rates, there’s upside risk inflation more than downside risk. It’s more likely that inflation will rise to 3% than that it will fall from where it is now down to 2%.

Why have we seen this fall in inflation toward 2% so far? Well, it’s because more of that nominal growth has come from real growth than can be reasonably expected over the long term. The reasons for that are pretty obvious. First, we’ve had the unwinding of all the supply snafus associated with COVID.

We’ve also had the development of new ways of conducting business. There is more working from home than there used to be, though there’s some back off from that. Those things give you a temporary burst in productivity growth. On top of that, you’ve seen increases in labor force participation rates. Well, that’s great, but those can’t continue forever. You’re not going to have 100% labor force participation rates. We’re already near record highs with labor force participation. That upward movement isn’t going to continue. 

We had a surge in immigration. Even the Biden administration has been clamping down on immigration in the last several quarters. Depending upon who’s elected president, you’re going to see tighter or looser immigration controls, but you’re certainly not going to see the growth in the number of immigrants that we’ve seen over the last four years. It’s definitely going to slow relative to that. We’re going to see slower growth in immigration. We’re going to see less increase in labor force participation rates. We’re likely to see an end to this burst in productivity growth.

All of those things suggest that we’re not going to continue to see such strong real output growth going forward without inflation moving upward from where we are now. That has nothing to do with new fiscal stimulus, which, of course, is another can of worms, or potential tariffs, which is another potential influence going forward. Even ignoring that, I think the risks are to the upside on inflation right now.

That’s an example of how in real time, I, at least, monitor different measures of nominal spending growth, factor in reasonable estimates of potential real growth going forward, and come up with an assessment of the prospects for inflation moving forward. By looking at these nominal spending trends, I also get a sense of whether policy has been truly restrictive or not.

It’s not just, of course, monetary policy. There’s also a question of fiscal policy that feeds into that. The net effect, if you’re pursuing a restrictive policy, is going to be to slow the rate of nominal spending growth, and that’s just not what we’ve seen.

Beckworth: You’ve answered a question that I was going to pose to you, and that is, do you think the robust growth in nominal GDP has come from a permanent rise in potential real GDP? Your answer is no. There’s not a permanent rise in potential real GDP. We should be worried or mindful, at least, of the robust growth in nominal GDP, because it might be telling us something about the future.

Koenig: I think certainly you have to recognize that as a very real risk. Nobody knows for certain what the economy’s growth potential is going forward. There are, I think, good reasons for thinking it’s less than the real growth that we have seen in recent years.

Beckworth: Which is being manifested, arguably, in the long-term Treasury yields. The Fed cut rates 50 basis points, and now the 10-year Treasury yield has gone back up. As of this recording, it’s at 4.3. It was below 4. It’s now at 4.3, which might be consistent with a higher expectation of future nominal GDP growth, higher r-star in the future, due to budget deficits, could be any number of things going on there. 

Nominal GDP Targeting and the Fed’s Upcoming Framework Review

Okay, Evan, in the time we have left here, any final thoughts on nominal GDP targeting, especially that we are now in a new Fed framework review and whether they should look at it as a potential framework?

Koenig: My strong hope is that the Federal Reserve in this upcoming strategy review will consider a broader range of policy strategies than they did in their last strategy review. And that, in particular, that they will pay more attention to nominal GDP targeting. This isn’t a cure-all for all the economy’s problems by any stretch of the imagination, but there are good reasons to think that it would be a step forward. If nominal GDP targeting is given consideration, it has to be a fair fight.

By that, I mean you can’t just include one type of nominal friction in your model economy if you’re evaluating different monetary policy strategies. If you only include Calvo-style staggered pricing in your economy, that’s going to steer you very strongly in a particular direction. If you’re going to give nominal GDP targeting a fair chance, you have to consider the possibility that people have fixed nominal debt obligations and the implications of that.

That’s a much more complicated problem because it means you can’t use a representative-agent economy the way you can with a sticky-price economy. The downside risk—we talk about risk management all the time. What nominal GDP targeting is especially well suited to is preventing the severe financial crises that have always materialized in our worst recessions. If you’re trying to do risk management, if you’re trying to insure yourself against major downside outcomes, it’s a financial crisis that you need to worry about. You want to have a strategy that will help you avoid those sorts of financial crises.

One side note, in our earlier discussion, I talked about how the advantage that nominal GDP targeting might have if you’re up against the zero lower bound. I also think that it reduces the chances that you’ll hit the lower bound in the first place because I think one reason that the market-clearing real interest rate, r-star, drops is because of financial strains. There have been a number of research papers that have pointed this out, that the market-clearing, risk-free real interest rate, plunges when you have a financial crisis or there are financial strains in the economy.

Insofar as nominal GDP growth reduces those financial strains, you’re less likely to see big drops in r-star. Another reason to give nominal GDP targeting serious consideration motivation helps you against supply shocks, and it may also help prevent you from facing the worst policy environment, which is when you’re up against the zero lower bound.

Beckworth: Okay. This has been great, Evan. Thank you so much for coming on the podcast again. This has been Evan Koenig. Appreciate your time.

Koenig: You bet. Thanks, David.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. Dive deeper into our research at Mercatus.org/monetarypolicy. You can subscribe to the show on Apple Podcasts, Spotify, or your favorite podcast app. If you like this podcast, please consider giving us a rating and leaving a review. This helps other thoughtful people like you find the show. Find me on Twitter @DavidBeckworth and follow the show @Macro_Musings.