The Federal Reserve is embarking on a new assessment of its monetary policy framework, a process last undertaken in 2020 that gave birth to the “Flexible Average Inflation Targeting” (FAIT) strategy. Theoretically, FAIT should have functioned well, but it appears the Fed may have mislaid the concept of “average” along the way.
In a recent podcast with David Beckworth, Evan Koenig dissected the pitfalls of monetary policy in 2021:
Currently, another case that illustrates your inquiry is found in an article I co-authored with Tyler Atkinson and Ezra Max that was published in January 2022. Although we wrote it in late 2021, it relied on third-quarter GDP data from that year. We were prompted to write it because, if you projected nominal GDP growth based on pre-COVID trends—keeping in mind the Fed’s 2% inflation target and a long-term economic growth estimate of 2%—the economy was essentially at full employment before the pandemic. Therefore, the logical trajectory for nominal GDP would have been a steady 4% growth rate extending from late 2019.
We charted this 4% growth path, tracking nominal GDP since the onset of the COVID recession. By the third quarter of 2021, we were just returning to that aspirational target, which should have been a cause for celebration. However, the issue emerged when we examined the forecasts from private analysts and, although we couldn’t address it at the time, even internal Fed predictions suggested that nominal GDP would significantly overshoot this target and not revert back to it.
Our contention was clear: while the recovery appeared successful thus far, significant trouble loomed ahead unless the Fed began withdrawing its accommodative policies. We argued that we should have been in a neutral policy stance—notably, one that stabilizes nominal GDP growth at 4%. The recovery was complete, yet, instead of applying the brakes, the Fed had its foot firmly pressed on the accelerator, with interest rates pinned to zero and ongoing asset purchases.
In their Dallas Fed paper, the authors explicitly stated that the Fed’s policy at the end of 2021 was excessively expansionary:
But will nominal GDP (NGDP) maintain that trajectory? Professional forecasters are skeptical. Blue Chip forecasters predict that NGDP growth will exceed 4.0 percent from now until 2025. After that, growth is expected to stabilize, leaving the level of NGDP 4.2 percent above its trend, as illustrated in the accompanying chart.
If the pandemic doesn’t have a lasting impact on real output, this uptick in NGDP suggests a price level that is 4.2 percent higher than pre-pandemic levels. If the pandemic does leave a lingering negative effect on output, the resulting price increase could be even greater. The expectations of Fed policymakers, as reflected in the latest Summary of Economic Projections, align broadly with this view.
An NGDP-targeting approach would advocate for a more accelerated withdrawal of policy support than currently anticipated to align incomes closer to their pre-pandemic trends and to mitigate the long-term inflationary impacts resulting from the pandemic.
They even produced a chart illustrating the undesirable outcome they were concerned about.
The actual NGDP overshoot turned out to be even more severe than anticipated. At least the economists at the Dallas Fed recognized that the policy was overly expansionary. One can only hope that those tasked with revising the Fed’s policy framework heed the insights of those who accurately identified the missteps of 2021. After all, when errors are made in policy formulation, it only seems prudent to consult the voices that foresaw those miscalculations.
