With the trend growth rate of productive capacity being 3%, a 2% inflation rate should imply a 5% growth rate in nominal expenditure. During the period of the "great moderation," nominal expenditure, as measured by total final sales of domestic product, has had a trend growth rate of slightly more than 5%.
Targeting the growth path, however, is not the same thing as targeting the growth rate.Nominal expenditure has been below its trend growth path since 2006. While the gap remained small and stable until the fourth quarter of 2007, it has grown and has become alarmingly large after the fourth quarter of 2008 and first quarter of 2009. Second quarter 2009 total final sales was $14,327 billion. If it had continued to grow on the 5% trend growth path, it should have been $15,657 billion. The shortfall for the second quarter was nearly 9%.
Scott Sumner has argued for keeping nominal output on a stable growth path. He has proposed targeting expected nominal output one year into the future. The difference between nominal expenditure (total final sales) and nominal output (GDP) is inventory investment. Sumner's target for nominal expenditure, ignoring expected changes in inventory investment, and continuing with the 5% growth path would be for total final sales in the third quarter of 2010 to be $16,757 billion.
Last year, I agreed with Sumner that the Fed should maintain its past 5% growth path of nominal expenditure. While I favored a 3% growth path, the middle of a financial crisis was a poor time to engineer a disinflation. However, now that nominal expenditure is so far below that trend, I favor making an adjustment in the target growth path starting at the third quarter of 2008.
Given that adjusted target growth path of nominal expenditure, and continuing with targeting one year into the future, the proper target for third quarter 2010 total final sales of domestic product is $15,961 billion. That implies a slightly less than 12% growth rate for total final sales over the coming year. And then, for the fourth quarter 2010, it would be $16,081 billion, which would be an increase from the third quarter 2010 at a 3% annual rate.
How should the Fed manage that feat? First, it should publicly commit to nominal expenditure growth path targeting. It should commit to having total final sales in the third quarter of 2010 to be $15,961 billion. It should say nothing about what it expects the federal funds rate to be or how fast the CPI will be rising each month.
Second, it should stop trying to prop up short term, low risk yields by paying interest on bank reserve balances. If banks, foreign investors, domestic investors, or anyone else wants to hold perfectly, or nearly perfectly liquid, and zero or near-zero risk assets, then they should pay a little for that privilege.
And finally, the Fed should get serious about quantitative easing. The Fed should expand base money enough, whatever that might be, so that the expected value of total final sales is on target.