Thursday, January 30, 2014


Market monetarists, who would have the Fed target an NGDP growth trajectory, often talk about the relationship between Nominal GDP (NGDP) and Real GDP (RGDP).  In short, it's not a fixed-pie relationship, where real growth goes up when inflation goes down.  It's not even a non-relationship, where they go up and down independently.  In fact, under conditions where inflation is not excessive, higher inflation tends to come with higher real growth.

Here, I have graphed RGDP on a scatterplot with an inflation measure.  What we can see here is that there appears to be some level of inflation - around 4% or so - above which the balance of positive and negative effects from inflation switches and becomes increasingly negative.  This was the case from 1973 to 1982.  When we combine all the periods since 1948, we can see the humped relationship.
If we take out the period before 1973, which had more volatile GDP behavior, the relationship is even more clear:
Demographics are certainly putting a damper on aggregate growth, and the correlations run in all directions here.  But, since 2009, the sideways movement in the Employment-Population Ratio has been about what one would predict, given the level of RGDP growth we have had.  Where would we be now, if the Fed had kept a 4% inflation target instead of a 2% target?  The nice thing about NGDP targeting is that they wouldn't have to make that distinction explicitly.  If they had a 5% NGDP target, inflation would find its own level, and wage and bond markets would be able to clear more easily.

In the meantime, it's worth noting that having an inflation rate consistently below 2% may be just as bad a policy as having inflation around 6% or 7%.  I don't see any reason to be afraid of 4% inflation, at least on occasion.  What caused us to be so afraid of 4% inflation?  What awful historical incident was triggered by 4% inflation?


  1. Couple of questions/points.

    First, have we actually determined a viable way to target NGDP yet? Last I heard, it was something that everyone thought was a great idea, but no one knew how to do. Something nebulous about targeting some sort of futures market - but how viable is that for a central bank to do reliably, and how much do we expect to gain over the current Fed toolkit?

    Second, the trend is pretty clear for 83-13, but it looks to me like the trend lines for the other periods are mostly being defined by outliers.

    Third (oops, I guess I have three points), are we sure YOY % change is the best metric for these numbers? What are those numbers, exactly? Are you talking about the difference between two years' average rates of change? Or, are you talking about the difference between two point-in-time rates of change? The latter strikes me as being a slightly better number (because it avoids the pitfalls of taking the average of averages), but then why not just use quarterly numbers to get a better handle on the actual trend?

    Just thinking out loud, mostly....

  2. Good questions, Ryan.

    The futures market seems viable to me, but even if it doesn't help, generally, targeting NGDP instead of inflation seems to me like it would solve some problems without creating new ones.

    These are YOY % changes in levels, which I used to strike a balance between getting rid of noise and giving timely measures. It seems to me like using the first difference, more or less, covers the policy decisions. The other options get to complicated or noisy, I think.

    You're right. The 1948-72 data doesn't have much of a correlation, and the outliers account for most of it. Getting rid of the outliers in the post '72 data improves the correlation, though.

  3. I would also question assuming no change in measurement accuracy over all levels of inflation. One thing I will note from observation- the higher the inflation rate, the greater effort a government will make in suppressing the measured number (see Argentina and Venezuela for today's examples).

    1. Hmm. Good point. If inflation tended to be undermeasured at high levels, RGDP would be overstated. I don't know how much of a problem that would be in the US, although there were various price controls in the 70's which would muddle up the data, and, to be honest, I don't know exactly what the effect would be.

      Another caveat is that the high inflation data is really a single episode over a number of years, so the low RGDP could just be a coincidence.

      It still seems to me that inflation under 4% or so doesn't appear to be damaging. I suppose that if the Fed had a centered target of 2% inflation instead of a sort of maximum target of 2%, then 0% to 4% would basically be the working range.