We hear it all the time – are we heading for a recession (a hard landing) or a soft landing in the US economy?
The question, of course, is what a soft landing is. A way to answer this question is to determine whether the Federal Reserve conducts monetary policy in such a way that it does not create monetary imbalances that spill over into the real economy and create accelerating inflation or a general glut (a recession).
And the market monetarist answer to this challenge is that the Fed should conduct monetary policy in a predictable and transparent way to ensure a steady growth rate in nominal spending, often measured as the growth rate of nominal GDP.
Market monetarists like Scott Sumner and myself have further argued that the Fed and other central banks should not target present or, even worse, lagging NGDP, but rather future NGDP. However, contrary to inflation – where we can find market expectations for future inflation – there do not exist NGDP futures from which we can make forecasts about future NGDP growth.
Consequently, market monetarists argue that more traditional measures of the monetary policy stance, like money supply growth (relative to the growth of money demand) and interest rates (relative to the natural interest rates), should be supplemented with reading the markets and combining signals from exchange rates, commodity prices, stock prices, and bond yields to assess whether nominal spending is stable or accelerating/decelerating.
However, such indicators, while useful in the conduct of monetary policy, are harder to comprehend for the wider public and are often hard for policymakers to communicate.
Therefore, I am today happy to announce that I might have found something that makes this task easier going forward.
A new weekly NGDP growth indicator
Earlier today, I was reminded of a weekly indicator of real GDP growth created by Daniel Lewis, an economist at the Federal Reserve Bank of New York, Karel Mertens, a senior economic policy advisor at the Federal Reserve Bank of Dallas, and James Stock, a Professor at Harvard University.
The index uses high-frequency data such as Redbook same-store sales, Rasmussen Consumer Index, new claims for unemployment insurance, continued claims for unemployment insurance, etc., as an indicator of real GDP growth.
I must admit that I had forgotten about the index and really didn’t think it was all that accurate. However, when I was reminded of the index today by a tweet by Bob Elliot (who, by the way, often comes close to arguing like a market monetarist) where he noted that the Lewis-Mertens-Stock indicator was actually signaling an acceleration in US real GDP growth I once again had a look at the indicator and I must say I was impressed how accurate it has continued to be.
This, combined with the fact that I love real-time and high-frequency indicators, made me think – why don’t we have a weekly NOMINAL GDP indicator?
So, I had to create one. At first, I thought I would use truflation.com’s daily CPI indicator for the US, but I don’t have access to that data for a longer period of time, and I would at the same time like to have a forward-looking element in my indicator, so I instead opted for using daily market expectations for US 5-year-5-year inflation.
I admit this can seem a bit odd with a rather unusual combination of present-time and foreward-looking indicators, but adding these two variables together historically tracks actual NGDP growth very well, as the graph below shows, and at the same time, it adds an element of both being forward-looking and high-frequency. Something that should be very useful for monetary policymakers.
Obviously, it would be preferable to have an annualised growth rate over, for example, three months (12 weeks) rather than a year-on-year growth rate, but for now, this will have to do.
Fed’s implied target for NGDP and the weekly NGDP indicator
The Fed officially targets 2% inflation (measured by the PCE deflator). If we assume that potential real GDP growth is also around 2%, then the Fed’s implied NGDP growth target should be 4% annual growth. Here we refrain from discussing that a level target rather than a growth target would be preferable.
However, if we look at the period from 2010 to early 2020, the weekly NGDP indicator averaged around 4.5% growth. However, during the same period, US PCE inflation was quite close to 2%.
Hence, it is probably fair to assume that as long as the weekly NGDP indicator is around 4-4.5%, the Fed will also over time deliver on its 2% inflation target. The graph below shows the development of the weekly NGDP indicator since mid-2022.
We see that early in the period (and before), NGDP growth clearly was too high to ensure 2% inflation, and monetary tightening, therefore, was clearly warranted. However, it is also clear that towards the end of 2022, NGDP growth slowed too much, and in this regard, it may be worth remembering that in early 2023, we saw considerable financial and banking distress in the US.
However, after the Fed in March 2023 started to soften its rhetoric, the NGDP indicator gradually started to improve. The Fed ended its hiking cycle in the late summer last year, and since then, the weekly NGDP indicator has been very close to the 2010-20 median growth rate of 4.5%.
Hence, for nearly half a year, the Fed has been able to ensure very stable NGDP growth (as during the 2010-19 period).
Effectively this means that monetary policy now is more or less perfectly balanced, so at the same time ensuring a growth rate of nominal spending that will ensure that US inflation returns to 2%, while at the same time avoiding a recession. This is the much-talked-about “soft landing”.
To cut or not to cut?
However, the challenge now is to ensure that this continues to be the main scenario going forward. Some Fed officials over the past week have tried to signal to investors that they are wrong in expecting at least 5-6 rate cuts of 25bp each during the eight FOMC meetings of 2024.
I believe these Fed officials are playing with fire. The fact is that monetary policy presently is nearly perfectly calibrated – it is neither too tight nor too easy. It is just right. And in this regard, it should be remembered that if the Fed delivers what the markets expect in terms of rate cuts, it is a neutral monetary policy – and not an easing of monetary policy.
Monetary policy is only eased if the Fed delivers more cuts than already priced by the markets. So, by trying to signal fewer rate cuts than priced by the market, Fed hawks effectively are trying to push NGDP growth below what is desirable, and if continued, are likely to cause the US economy to fall into recession.
That being said, it is also notable that in recent weeks US bond yields have increased a bit and so has the weekly NGDP (and real GDP) indicator.
This, to me, is an indication that monetary policy has not become too tight either. This is even causing me to rethink my otherwise held view that there was room for some downward pressure on US 10-year bond yields, and I must admit that I increasingly think that we have seen a slight upward move in long US productivity growth, which would cause the natural interest rate to increase a bit.
Furthermore, lower global demand for US bonds, caused particularly by reduced Chinese savings (a reduction in the FX reserve) combined with excessively easy fiscal policy in both Europe and the US, is likely also contributing to this. However, none of this is dramatic – at least not judging from our new weekly NGDP growth indicator.
A way forward for the Fed
In conclusion, at least for now, it seems like Jay Powell and the Federal Reserve have managed to ensure a soft landing by ensuring stable nominal spending growth around 4-4.5%, and that this is consistent with the Fed’s 2% inflation target.
Therefore, the Fed could do a lot to actually embrace a high frequency indicator of nominal spending growth like the one I have suggested and announce that it will track it closely to ensure 4-4.5% growth in nominal spending.
It could continue to use interest rates as its primary policy instrument, but the Fed needs to communicate in terms of a further interest rate path relative to market pricing. This would presently imply that the Fed openly should say that “our indicators for nominal spending continue to develop in a way consistent with our 2% inflation target, and we therefore plan to deliver rate cuts in line with present market pricing”.
Furthermore, if for example the weekly NGDP indicator moves up and above 5%, it certainly would be justified by the Fed to signal that it will deliver fewer rate hikes than the markets are presently pricing – and vice versa if the indicator moves down towards and below 4%.
If the Fed operated in such a way, the Fed basically would not have to do much more than publish a weekly quasi-forward-looking NGDP growth indicator and set interest rates according to market expectations.
Monetary policy then would become fully rule-based, and there would be little need for any other communication from the Fed or any in-house/FOMC forecasting. The market would then take care of most of the lifting in monetary policy.
But I am probably dreaming…
PS if the Fed keeps NGDP growth close to 4-4.5% and the we at the same time see an acceleration in productivity, which I think is likely (see my post on this topic here) then inflation might drop below 2%. That should just be welcomed as long as it reflects higher productivity growth and this own its own is an argument why the Fed should target NGDP growth rather than inflation.
PPS the second graph above was created using ChatGPT 4.0 (Data Analyst) as is the cartoon below. AI is changing the world – and making economic analysis easier and even more fun.
