Matt Yglesias just directed me this tweet:
Conor Sen may be right about the need for further rate cuts. But I worry about the Fed’s policy focusing more on the unemployment rate than the GDP growth rate. (Sen may have been referring to real GDP growth, but I will focus on NGDP growth, which is a positive change in monetary policy.)
The Fed’s policy between the late 1960s and 1981 was extremely unstable, leading to inflation that was much greater than the recent episode. The cause of this policy crisis is clear; the Fed focused on the unemployment rate and largely ignored the nominal GDP growth rate.
To be effective, monetary policy needs a common anchor. That’s because policymakers don’t know the natural rate of unemployment, or the natural rate of output. Even a small error in measuring the natural rate of unemployment can cause inflation to spiral out of control. Conversely, although NGDP guidance may not be precise, any policy errors arising from NGDP guidance are likely to be relatively small.
Between the late 1960s and the 1980s, the natural rate of unemployment rose steadily. In the textbooks of the 1960s, the natural rate of unemployment was about 4%. By the 1980s, rates were closer to 6%. It appears that the natural rate of unemployment was rising, and that Fed policymakers were chasing an impossible goal. I don’t know if there has been an increase in the natural rate of unemployment recently, but it certainly is possible. Targeting NGDP completely avoids the need to measure the natural rate of unemployment. There is no natural rate of NGDP growth—it is entirely a policy decision.
You may wonder if inflation provides the primary anchor for monetary policy. Why didn’t the Fed put equal weight on money supply and unemployment? That kind of policy would certainly be better than focusing on a single concept of unemployment, and that may have been what Sen had in mind. But inflation is a flawed indicator because it is affected by both supply and demand shocks. NGDP is a pure measure of demand shocks, and thus a better target for monetary policy.