The Importance of Targeting Nominal GDP Over Inflation in Monetary Policy
In a recent post by Scott Sumner, he discusses the factors that contribute to monetary policy mistakes, specifically focusing on having the wrong target and an instrument setting unlikely to hit the target. This led to a discussion in the comments section, where a reader named John raised an interesting point about how market participants should forecast inflation or nominal GDP.
Sumner argues that there are cases where understanding that “nominal GDP is high because the Fed let nominal GDP be high” can be a useful way to approach the problem, even if it may not provide a complete explanation. He uses an analogy of a car crash to illustrate the point that sometimes simpler explanations can be more useful than complex ones.
Looking back at the Fed’s actions in late 2021, it becomes clear that they were aware that nominal GDP was rising well above trend. Despite this knowledge, they failed to adjust their policy to prevent an overshoot. This is where the concept of level targeting comes into play. By targeting nominal GDP, the Fed could have avoided the significant inflation surge experienced in the following years.
A comment by Rajat highlights a conversation between David Beckworth and Jason Furman, where Furman expresses skepticism about nominal GDP targeting. However, Sumner disagrees with Furman’s assessment, arguing that tightening policy in early 2021 would have been necessary to prevent a significant overshoot.
Sumner emphasizes the importance of having the right target in monetary policy decisions. While market guidance can be useful, it is not a substitute for having a clear strategy like NGDP level targeting. He suggests that a 90% focus on NGDP targeting and a 10% focus on market guidance would be the ideal approach.
In conclusion, Sumner stresses the significance of targeting nominal GDP over inflation in monetary policy. By setting the right target and following a strategic approach like NGDP level targeting, central banks can avoid costly mistakes and ensure stable economic growth. Market guidance can be helpful, but it should not be the primary focus when making policy decisions.
