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Conor Sen may well be correct about the need for further rate cuts. But I worry about a Fed policy that focuses more on the unemployment rate than the GDP growth rate. (Sen may have been referring to real GDP growth, but I’ll focus on NGDP growth, which is clearly the right variable for monetary policy.)Fed policy between the late 1960s and 1981 was extremely unstable, leading to an inflation burst that was far greater than the recent episode. The cause of this policy disaster is clear; the Fed focused on the unemployment rate and largely ignored the growth rate of nominal GDP.To be effective, monetary policy needs a nominal anchor. That’s because policymakers do not know the natural rate of unemployment, or the natural rate of output. Even a slight error in estimating the natural rate of unemployment can cause inflation to spiral out of control. In contrast, while NGDP targeting may not be precisely optimal, any policy errors resulting from NGDP targeting are likely to be relatively small.Between the late 1960s and the 1980s, estimates of the natural rate of unemployment crept steadily higher. In 1960s textbooks, the natural rate of unemployment was estimated to be roughly 4%. By the 1980s, estimates were closer to 6%. It seems likely that the natural unemployment rate was rising, and that Fed policymakers were chasing an impossible goal. I don’t know if there has been a recent increase in the natural rate of unemployment, but it is certainly possible. Targeting NGDP entirely avoids the need to estimate the natural rate of unemployment. There is no natural rate of NGDP growth—it is entirely a policy choice.You might wonder if inflation provides a nominal anchor for monetary policy. Why not have the Fed put equal weight on inflation and unemployment? That sort of policy would certainly be better than a single-minded focus of unemployment, and indeed may have been what Sen had in mind. But inflation is a flawed indicator because it is impacted by both supply and demand shocks. NGDP is a cleaner measure of demand shocks, and thus a better target for monetary policy.More By This Author:Goolsbee Vs. Summers What Ails The Anglosphere? Why sanctions often fail to work
Conor Sen On Fed Policy
