Traditionally, central banks have focused on inflation targeting, but NGDP level targeting provides a more comprehensive picture by encompassing both inflation and real GDP growth over time.
However, real-time data on NGDP is not readily available. This challenge led me to develop a proxy for weekly NGDP growth.
In January 2024, I introduced this approach in my blog post “Did Jay Powell just deliver a near-perfect soft landing? Get the surprising answer from a new weekly NGDP indicator.”
This NGDP growth proxy has become an invaluable tool for real-time economic analysis for me – now I just hope the Fed would adopt it as well.
Constructing Our Weekly NGDP Growth Proxy
Our weekly NGDP growth proxy is constructed using a combination of high-frequency data points that reflect real-time economic activity. Specifically, we use:
- Market expectations for US 5-year-5-year forward inflation: This is a forward-looking indicator that reflects market expectations of inflation over a future five-year period, starting five years from now.
- Weekly Economic Indicator (WEI) from the Federal Reserve Bank of New York: The WEI combines several high-frequency data points, such as retail sales, unemployment claims, and consumer sentiment indices, to provide a near real-time indicator of economic activity.
By combining these indicators, we can track the growth rate of nominal spending with a high degree of accuracy and timeliness. Historically, this combination has tracked actual NGDP growth very well, providing a robust tool for economic analysis and policy formulation.
Our weekly NGDP growth proxy can be formally expressed as:
n_proxy_t = α * Inflation_Expectations_t + β * WEI_t + ε_t (1)
Where n_proxy_t is our NGDP growth proxy, α and β are estimated coefficients, and ε_t is an error term.
We can see from the graph below that our NGDP proxy has closely followed the actual development in NGDP growth over the last 15 years. However, it has the significant advantage of providing us with near real-time, week-by-week data. Additionally, because we use market expectations for inflation, the proxy is also leading in relation to the actual NGDP growth.
The Rule for Targeting NGDP Growth
Market monetarists like Scott Sumner, David Beckworth and myself traditionally argue for an NGDP level target rather than an NGDP growth target.
However, our proposed medium-term growth target represents a more pragmatic approach to ensure economic stability.
To guide monetary policy, I propose a rule-based framework that targets a long-term NGDP growth rate of 4.5%.
This target is grounded in the Federal Reserve’s official 2% inflation target and an assumed potential real GDP growth rate of around 2-2.5%.
However, a purely growth-based target may not adequately address historical deviations from the target path. To compensate for periods of undershooting or overshooting, I introduce a medium-term NGDP target rule, which can be formally expressed as:
n_target_t = n* – λ(n_MA_t-2 – n*) (2)
Where:
- n_target_t is the medium-term NGDP growth target at time t
- n* is the long-run NGDP growth target (4.5%)
- n_MA_t-2 is the 6-quarter moving average of NGDP growth, lagged by 2 quarters
- λ is an adjustment coefficient (set at 0.75 in our baseline model)
This formula adjusts the target based on the historical performance relative to the long-term target, effectively compensating for past deviations. If NGDP growth has been below target, the medium-term target allows for a period of higher growth to bring the economy back on track, and vice versa.
To visualize how this rule works in practice, let’s examine the following graph:
This graph clearly demonstrates the relationship between actual NGDP growth (blue line), our proposed medium-term NGDP target (yellow line), and the long-term NGDP target of 4.5% (green dashed line).
Several key observations can be made:
- Pre-pandemic period (2010-2019): Actual NGDP growth generally fluctuated around the 4.5% long-term target, with the medium-term target adjusting to compensate for deviations.
- Pandemic shock (2020): We see a dramatic drop in NGDP growth, followed by a sharp rebound. The medium-term target adjusted significantly to compensate for this extreme deviation.
- Post-pandemic recovery (2021-2022): NGDP growth overshot the target, leading to a period of monetary tightening.
- Recent stabilization (2023-2024): As observed in early 2024, for nearly half a year, the Fed has been able to ensure very stable NGDP growth around the 4.5% target. This is evident in the convergence of all three lines towards the end of the graph.
This visual representation supports our argument that the Fed has implicitly been following a rule similar to our proposed medium-term NGDP target rule.
The medium-term target (yellow line) has consistently guided actual NGDP growth back towards the long-term 4.5% target, even in the face of significant economic shocks.
This does not mean that monetary policy has been flawless. For instance, it seems evident that monetary policy became overly expansionary during 2021 (the blue line was significantly above the yellow line). However, at least from 2022 onwards, the Fed managed to get back on track – a stance it has largely maintained to date.
Relation to the McCallum Rule
Our approach bears significant similarities to the McCallum rule, a monetary policy rule proposed by economist Bennett McCallum.
The McCallum rule focuses on adjusting the monetary base to achieve a target path for nominal GDP. It can be formally expressed as:
Δb_t = n* – Δv_a + λ(n* – n_t-1) (3)
Where:
- Δb_t is the change in the monetary base
- n* is the target NGDP growth rate
- Δv_a is the average growth rate of base velocity
- n_t-1 is the previous period’s NGDP growth rate
- λ is an adjustment coefficient
In essence, the McCallum rule aims to stabilize nominal GDP growth by adjusting the monetary base to offset changes in money velocity and align with real GDP growth. Both the McCallum rule and our medium-term NGDP target rule aim to stabilize nominal GDP growth.
Comparison of Coefficients
To understand the similarities and differences between our proposed medium-term NGDP target rule and the McCallum rule, it is useful to compare the coefficients in the respective equations.
Our Medium-Term NGDP Target Rule:
n_target_t = n* – 0.75(n_MA_t-2 – n*)
In this equation:
- The target NGDP growth rate is n* (4.5%)
- The coefficient for the deviation of the moving average of NGDP growth from the target is -0.75
- The adjustment is based on a 6-quarter moving average, lagged by 2 quarters
The McCallum Rule:
Δb_t = n* – Δv_a + λ(n* – n_t-1)
In this equation:
- The coefficient for the velocity of money is -1
- The coefficient for the deviation of NGDP growth from the target is λ (typically set around 0.5)
- The adjustment is based on the previous period’s NGDP growth
While both rules aim to stabilize NGDP, our medium-term target rule explicitly compensates for past deviations from the target through a specific coefficient (-0.75) and a lag (6-quarter moving average, lagged by 2 quarters), providing a structured way to return to the desired NGDP growth path.
In contrast, the McCallum rule focuses on adjusting the monetary base considering changes in the velocity of money and the most recent NGDP growth rate.
The choice of a -0.75 coefficient in our rule allows for a more aggressive adjustment compared to the typical λ value in the McCallum rule. This reflects our emphasis on medium-term stability and the need to compensate for cumulative deviations over time.
Furthermore, our use of a moving average lagged by two quarters provides a smoother adjustment process, reducing the impact of short-term fluctuations and allowing for a more gradual return to the target path.
Both rules share the fundamental principle of targeting NGDP growth, but our proposed rule is designed to be more forward-looking and to provide a clearer path for expectation formation among market participants.
By explicitly targeting a medium-term NGDP growth rate, our rule may be more effective in anchoring long-term expectations while still allowing for short-term flexibility in monetary policy.
Where We Are Now
The current state of the US economy illustrates the effectiveness of this implicit rule.
Our analysis shows that after a period of monetary tightening in response to high NGDP growth rates, the Federal Reserve’s policies have managed to stabilize NGDP growth around the long-term target of 4.5%. This has been achieved without official acknowledgment of following a rule akin to the McCallum rule.
Effectively, this means that monetary policy is now more or less perfectly balanced, ensuring a growth rate of nominal spending that will allow US inflation to return to 2% while avoiding a recession – the much-talked-about “soft landing”.
Implications of an Implicit McCallum Rule
The realization that the Federal Reserve has been implicitly following a McCallum-like rule has significant implications for both policymakers and market participants.
Firstly, it underscores the importance of NGDP targeting as a superior policy framework compared to traditional inflation targeting.
NGDP targeting inherently adjusts for both real economic growth and inflation, providing a more broad-based measure of economic health.
Secondly, this approach highlights the need for central banks to compensate for past deviations from their targets.
By ensuring that periods of undershooting are followed by periods of overshooting, central banks can maintain a more stable economic environment. This is particularly important in avoiding the pitfalls of purely reactive policies that can exacerbate economic volatility.
The Path Forward: Embracing a Rule-Based Approach
For the Federal Reserve, openly acknowledging and embracing a rule-based approach to NGDP targeting could lead to more effective monetary policy.
By clearly communicating its targets and the rules governing policy adjustments, the Fed can enhance its credibility and effectiveness.
This transparency would allow market participants to better understand the Fed’s actions, reducing uncertainty and fostering a more stable economic environment.
This approach would make monetary policy fully rule-based, reducing the need for extensive Fed communication or in-house forecasting. The market would then take care of most of the heavy lifting in monetary policy.
Moreover, if the Fed keeps NGDP growth close to 4-4.5% and we simultaneously see an acceleration in productivity, inflation might drop below 2%. This should be welcomed as long as it reflects higher productivity growth, further underlining why the Fed should target NGDP growth rather than inflation alone.
The adoption of a rule-based framework aligns with the principles of market monetarism, which advocate for predictable and transparent monetary policy. This approach can help prevent the kind of monetary imbalances that lead to economic disruptions, ensuring a more stable and prosperous economy for all.
A concrete way forward for the Fed could be:
- Embrace a high-frequency indicator of nominal spending growth, such as the one proposed in this article.
- Announce that it will track this indicator closely to ensure 4-4.5% growth in nominal spending in the long run.
- In the short term, use monetary policy instruments to hit the medium-term target for NGDP, which might be higher or lower than the long-term target, to make up for past policy mistakes (overshooting or undershooting relative to the long-term target).
- Continue to use interest rates as its primary policy instrument, but communicate in terms of a further interest rate path relative to market pricing.
- Pre-announce that if the zero lower bound on interest rates is hit, the Fed will initiate quantitative easing as long as the NGDP proxy is below the medium-term NGDP target.
By adopting this framework, the Federal Reserve would be acknowledging and formalizing the McCallum-like rule it has been implicitly following, leading to more transparent, predictable, and effective monetary policy.
Note: The drawing above is created based on an article by ChatGPT/DALL-E.
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