“In other words, the economic crisis not only overwhelmed the Fed’s inflation-targeting methods, but showed them to be deeply inadequate. Given the consequences of that failure, America’s policymakers now need to ask: Could the Fed have done better?
“It could have, had it set its sights not on inflation but on nominal gross domestic product — the sum of all current-dollar (non-inflation-adjusted) spending in the American economy. NGDP growth, which is made up of the inflation rate plus “real” (or inflation-adjusted) GDP growth, would have been a better indicator of the severity of the crisis. Between 2008 and 2009, NGDP declined at the fastest rate since 1938, while inflation (at least the “core” inflation rate, which excludes food and gas prices and which the Fed uses as its key inflation measure) raised no red flags. Because inflation cannot quickly adjust to such sudden drops in spending, this decline in nominal GDP brought about a sharp decline in real GDP — thus, a severe recession.
“In an important sense, the sharp drop in NGDP precipitated the crisis: It was the proximate cause, even if the housing crisis was the ultimate cause. This suggests that NGDP is useful not only as a predictor and indicator of trouble, but as a target for monetary policy. Setting a goal in terms of nominal GDP could provide a superior alternative to the Fed’s current inflation targets.”
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