NGDP

What the Fed Knew, and When

Zachary BartschLeave a comment

I’ve recently gone back and started listening to the archived episodes of the ‘Macro Musings’ podcast hosted by David Beckworth. The show started in 2016. At that time, there was still a sense of malaise after the 2007-2008 Great Financial Crisis (GFC) and the slow recovery that followed it. We were also in a prolonged low-interest rate environment.

A recurring theme is whether the Fed should have engaged in expansionary policy earlier than they did in response to the GFC. There are multiple ways to answer. It’s not helpful to say ‘knowing what we know now’. The Fed didn’t have that opportunity. It’s a little bit more helpful to say ‘if the Fed had a different target or different tools’.  The target and tools are higher-order policy decisions and changing them can be helpful in the future. But they typically can’t be changed with the flip of a switch. After all, the 2% inflation target itself rolled out over the course of decades.

The most awkward/damning question is “Given the target, tools, and data that the fed actually had, did they make the right decision?”. If the answer is ‘no’, then that warrants a serious investigation of individuals, groups, processes, etc. I don’t mean a legal investigation. I mean the decentralized kind in which public and expert trust can be affected.

A concept that Beckworth often mentions concerning Fed culpability/performance during the GFC is the problem of data revisions. Currently, we know what the revised data says about NGDP, inflation, employment, etc. But the Fed only had the contemporary numbers and immediate revisions. In a world where economic growth is lousy or stellar in a range of 1-3%, small revisions can matter a lot. For example, below are the 2001q1 NGDP revision values over time.

Revisions occurred twice by 2002q2, revising NGDP down by more than 2%. Subsequent revisions raised the value on record to nearly +3% of the initial estimate, before settling at a less elevated value. Sheesh! In a world where a 1% swing is a big deal, how can we possibly expect the Fed to succeed at managing aggregate demand?

Things are not so scary as they might seem. The Fed doesn’t much care about revisions to an individual quarter. Rather, they care about the direction of change over time. Whether future revisions increase GDP by 2% is unimportant. What’s important is whether one period’s value is lower relative to the earlier value. That’s the relevant difference that tells us how the economy is changing.

Now, in 2026, our current understanding of NGDP during the GFC follows the below pattern starting in 2005q1 (lest I omit important pre-trends). NGDP growth had weakened in 2007q4, turning negative in 2008q1. Weak growth resumed in 2008q2. Then we had near-zero or negative growth for the next five quarters. Of course, we’re now approaching twenty years later, so we have the huge benefit of hindsight and revisions. Keep in mind that the contemporary numbers aren’t available until the subsequent quarter. By the yard stick of NGPD, the Fed should have been loosening by Q3 or certainly Q4 of 2008 if they cared about supporting total spending. Maybe as early as Q2 is they were especially sensitive.  

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Don’t Cut Rates

James Bailey3 Comments

The Federal Reserve will probably cut rates next week:

I can’t advise them on the complex politics of this, but based on the economics I think cutting would be a mistake. I see one good reason they want to cut: hiring is slow and apparently has been for a year. But that could be driven by falling labor supply rather than falling demand, and most other indicators suggest holding rates steady or even raising them.

Most importantly, inflation is currently well above their 2% target, 2.9% over the past year and a higher pace than that in August. Inflation expectations remain somewhat elevated. Real GDP growth was strong in Q2 and looks set to be strong in Q3 too, and NGDP growth is still well above trend.. The Conference Board’s measure of consumer confidence looks bad, but Michigan’s looks fine.

Financial conditions are loose, with stocks at all time highs and credit spreads low. Its only September and we’ve already seen more Initial Public Offerings than in any year since 2021 (when the last big bout of inflation kicked off):

Source: https://stockanalysis.com/ipos/statistics/

Crypto prices are back near all time highs and crypto is becoming more integrated into public stocks through bitcoin treasury companies and IPOs from Gemini and Figure.

The Taylor Rule provides a way of putting all this together into a concrete suggestion for interest rates. Some versions of the rule say rates are about on target, while others including my preferred Bernanke version suggest they should be closer to 6%. To me this is what the debate should be- do we keep rates steady or raise them? I see good arguments each way, but the case for a cut seems very weak.

I look forward to finding out in a year or two whether I or the FOMC is the crazy one here.

* The Usual Disclaimer, hopefully extra obvious in this case: These views are mine and I’m not speaking for any part of the Federal Reserve System.

Europe Doesn’t Have to Be A Defenseless Museum

James Bailey2 Comments

America has withdrawn aid from Ukraine. Contra the Vice-President, we could easily afford to reverse this, and I hope we will. I know we could afford it because even the much poorer Europeans can, and I think they might finally be ready to try.

Until now, Europe has been fighting with both hands tied behind their back- letting their economic growth fall far behind America’s due to poor policy, and committing only a tiny share of that economy to defense. Here’s how Polish Prime Minister Donald Tusk put it:

500 million Europeans are asking 300 million Americans to defend them against 140 million Russians.

Europe may be significantly poorer than the US on a per-capita basis, but it has significantly more people, so the total size of their economy is almost as large as the US and over 4 times larger than Russia:

Source: my graph of World Bank data

But Europe has put only a small fraction of their economy toward defense for a long time. Russia alone spends more on their military than the rest of Europe combined despite their much smaller economy, by putting a much larger fraction of their GDP toward the military:

When European countries spend so little on their own defense, they have little to share with Ukraine. Many leaders complaining about the end of US support have contributed much less themselves, even as a share of their smaller economies:

Europe can be much stronger than Russia, but only if they start trying at least half as hard as Russia. Yes, Europe has poor demographics, but Russia’s are worse; Europe has many more military-age men:

Yes, Russia has nukes, but so do Britain and France, and France might actually take advantage of this.

Economically speaking, is this a good time for Europe to rearm? To me it looks fine. The best time would have been the late 2000s to early 2010s, both because it could have been in time to dissuade Russia from starting this war, and because their economic problems then were much more about a lack of aggregate demand. But right now inflation is fine at 2.4%, NGDP growth is fine at 4.3%, and 10-year bond yields the major countries are around 3-4%. Overall this looks like AD is currently about right, but markets expected that economic growth could turn negative this year, and a burst of defense spending could head that off:

This would be especially valuable if it can be paired with the supply-side reforms that European leaders know they should to do anyway, and that would allow for more growth without pushing up inflation. Europe has fallen far behind the US in productivity, to the point that it is now a bigger issue than their higher unemployment and lower hours worked in explaining why the US is much richer:

The silver lining here is that the further behind the US they fall, the faster they could potentially grow- catchup growth is easier than frontier growth, you just need to copy the technologies and implement the strategies already figured out by the frontier economies. Europe easily has the human capital to do this, they just haven’t had the will- have preferred to regulate new technologies like fracking and AI into oblivion, along with older technologies like nuclear power. They won’t drill for oil and gas themselves in the name of decarbonization but have spent hundreds of billions on Russian oil and gas just since the war began. But if they ever decided to change their policy, their economy could rapidly improve- like letting go of the rubber band you’ve been pulling back.

European leaders appear to finally be realizing this. The European Commission just proposed a 150 billion Euro joint defense fund. This week Germany proposed spending half a trillion on infrastructure and defense, sending European stocks above their previous all-time high set in the year 2000 (!).

The EU always used to be able to excuse their economic failings by saying “at least we brought peace to a continent formerly full of war.” But this is no longer the case. If they cannot settle the war on good terms, they have no excuse. The good news is that European decline has been a choice, and it is a choice they could decide to change at any moment. Victory awaits those who will it.