Inflation commentary can get extremely complicated, but I’m a simple man with a fairly simple approach to thinking about monetary policy. Rather than obsessing too much about inflation — which can be measured in different ways and is influenced by changes in demand and supply-side shocks — I find it useful to look at nominal gross domestic product (NGDP).
NGDP is just gross domestic product (GDP) before any adjustment for inflation, and GDP is just all the money spent across the economy by households, businesses, and governments.
So NGDP, even though it’s a bit of an unfamiliar indicator, is also a very simple one. Counting up the total amount of dollars spent across the economy isn’t a totally trivial task, and the official numbers are subject to error and revision. But it is absolutely the simplest part of the whole process. Calculating the rate of inflation is a much more conceptually difficult (how do you adjust for the changing quality of restaurant meals or haircuts?) and fraught enterprise. So even though the official names tend to call inflation-adjusted quantities “real,” NGDP has always struck me as considerably more real than RGDP. The former is an actual count of defined quantities (dollars spent) while the inflation-adjusted figures are necessarily an abstraction.
NGDP also lets you look past supply-side issues. Suppose car production is handicapped by a global semiconductor shortage, causing prices to rise. That could lead total spending on cars to go up (people keep buying cars, but they cost more) or it could stay flat (people buy fewer, but more expensive cars) or car spending could even go down if everyone gets sticker shock. By the same token, the rising price of cars could push aggregate spending upwards or it could be offset by the falling price of some other category of goods because people have shifted their spending into cars. It’s not that supply shocks aren’t important. But over the past year, I think the inflation conversation has focused too much on them and not enough on the fact that overall spending has been really high.
This brings us to the most recent Fed meeting. I spent more than 10 years consistently thinking that the Fed was erring too much on the side of inflation aversion, and I now think the reverse. Not because I’ve changed, but because this very simple indicator — NGDP — is now giving us a different message.
25 years of NGDP
The economist David Beckworth produces a quarterly history of NGDP and what he calls the NGDP gap: the difference between actual economy-wide spending and what you would expect if spending just grew at a steady pace. And I think this chart confirms the value of the indicator. It shows that spending started to slip in late 2007, giving us the beginning phase of what would become the Great Recession, then really fell off in late 2008. But what’s striking is that even after spending started to go up, it remained below the trend throughout Barack Obama’s presidency.
That whole time I was yelling at Congress to pass more stimulus, yelling at the Fed to do more quantitative easing, and mad at Janet Yellen for raising interest rates. Policymakers were, I thought, paying too much attention to the ups-and-downs of the commodity market and engaged in too much baseless speculation about why labor force participation had fallen when the obvious explanation was that total spending was too low.
Now if you look at the pandemic, you see another huge falloff in spending. And then you see a quick rebound as the economy starts to reopen. But what’s great is the rebound keeps on rebounding thanks to stimulus from Congress and a supportive Fed. At the very end of the line, though, you see that we’ve overshot the target and total spending is now higher than you would have expected based on pre-pandemic trends. That overshoot isn’t the only reason we’re seeing inflation. All the supply disruptions you hear about are real. They all matter. But it’s the context in which the supply disruptions are playing out. As of Q4 2021, total spending levels were both very high and rising very rapidly. Now here we are in mid-March of 2022 with a whole new set of supply shocks stemming from the Russia-Ukraine war, and I think the Fed should be trying to bring that spending curve down so it’s more in line with the trend. And they are not acting aggressively enough.
The Fed says it will miss its targets
The Fed, of course, rejects this NGDP indicator. Instead, they target two percent inflation (as measured by the Personal Consumption Expenditure Deflator) using a framework called Flexible Average Inflation Targeting (FAIT). The basic idea of FAIT is that if inflation deviates from the target for a while, you can make it up in the future with inflation that deviates in the other direction.
I have no idea whether these forecasts are correct, but let’s assume the Fed is forecasting correctly to the best of its ability. They are saying that they believe core inflation will be significantly above-target in 2022, a little bit above-target in 2023, and then slightly above-target in 2024 before settling down on-target at some point in the future.