Nominal Expenditure Targeting, What Is Our Hope?

I advocate a 3 percent growth path for nominal expenditure--Final Sales of Domestic Product. I favor backing up the shift to the new growth path to the third quarter of 2008. At that time, the level of nominal expenditure peaked at $14,584 billion. That was already 3 percent below the level consistent with the 5.4 percent trend growth path, $15,032 billion, however, my preferred target begins increasing at a 3 percent annual rate from that point. Sometime in the spring of 2009, I began to advocate that the Fed target this adjusted growth path one year in the future. For example, in second quarter of 2009, I proposed that the Fed target Final Sales of Domestic Product for the second quarter of 2010 to be $15,841 billion.

Sadly, the Fed didn't follow that advice and continued with a policy of promising to keep the Federal Funds rate at a very low level for an extended period of time. They are also committed to stable prices, which perhaps means increases in the core CPI at a 2 percent annual rate from wherever it happens to be.

Today, I am proposing that the Fed target Final Sales of Domestic Product in the first quarter of 2011 (one year from now) to be $16,202 billion. And, of course, at a level 3 percent greater each and every quarter in the future.

What might happen to nominal expenditures, inflation, and the growth rate of real output during 2010 and in future years? What do I hope would happen?

For the out years, I took the targeted growth path and divided by the CBO estimate of potential output to get an estimate of the price level. Clearly, I don't really believe that nominal expenditure will remain exactly on target or that nominal output will exactly equal Final Sales of Domestic product. Surely, there will be error and variation, though I believe it will be less than the error and variation in nominal expenditure that occurred during the Great Moderation.

What about the transition? Moving from the level of nominal expenditure in the fourth quarter of 2009, $14,503 billion to the target for the first quarter of 2011, $16,202 billion, is a 12 percent increase over 5 quarters. Suppose that inertia in the economy causes most of the adjustment to be next year. I assumed 15 percent of the adjustment in the second quarter, then 25 percent in the third quarter, and then 30 percent in the 30 percent in the fourth quarter.

The value of the GDP deflator was 109.9 in the fourth quarter of 2009. If total final sales is on target and the CBO estimate of potential output for the first quarter of 2011, $14,264 billion, is correct, then the equilibrium value of the deflator would be 113.58. That is a 3% increase. I assume that the adjustment of the price level is also back ended, 15 percent, then 25 percent, then 30 percent.

Real output is estimated for each quarter by dividing total final sales by the price level. So, what are the results? First, Final Sales of Domestic Product from 1984 until 2019.

The next diagram just focuses in on the Great Recession and the transition through 2014.

The quarterly growth rates during the transition are quite high. For the third quarter of 2010 the growth rate is 10.3 percent. It is 12 percent for the fourth quarter. And then 11.6 percent for the first quarter of 2011. During the Great Moderation, Final Sales of Domestic Product only grew at such rapid quarterly rates in 1984 and 1984. The quarterly growth rates between 2006 and 2014 are below.

While two quarters of near 12 percent growth are high, the annual averages are slightly less alarming. Nominal expenditures would rise at an 8 percent annual rate during 2010. While unusual, this is not unprecedented for the Great Moderation. The growth rate for Final Sales of Domestic product was 8.2 percent for 1988. The annual average growth rate for nominal expenditure are below.

The simulated price level is shown below. A 3 percent growth path for nominal expenditure should result in a stable price level in the long run, but the CBO estimates of slow growth of potential output for the next decade imply a continuing mild inflation.

Focusing in on the Great Recession and transition period, the temporary increase in the inflation rate is clear.

However, the quarterly inflation rates during the transition are not very high. This is clearer with the following diagram that shows the inflation rate for each quarter between 2006 and 2014.

The annual average inflation rate for the 2010 would be 2.44 percent. While substantially higher than 2009, this is almost exactly the trend inflation rate for the Great Moderation. In the out years, the inflation rate remains below 1 percent.

What about the real GDP?

The Great Recession is quite prominent. Focusing on the Great Recession and the transition, the rapid recovery of real output as it returns to the CBO estimate of potential output is clear.

The simulated growth rates show rapid growth in some quarters. In the third quarter of 2010 it is 7.5 percent. And then 8.7 percent in the fourth quarter and another 8.4 percent for the first quarter of 2011.

While there were no quarters in the Great Moderation with such rapid quarterly increases, the growth rate for the second quarter 1983 was 8.9 percent, the third quarter of 1983 was 7.8 percent and the fourth quarter of 1983 was 8.1 percent.

The simulated annual growth rate of real GDP for 2010 is 6 percent.

While the most rapid annual growth rate in the Great Moderation was 1984, at 5.4 percent, the growth rate for 1983 was 7.46 percent.

Perhaps there are more sophisticated ways of simulating the impact of shifting to a target for a 3 percent growth path of nominal expenditures. Further, there are other estimates of potential output that are even more pessimistic than the CBO's. Still, the opportunity for a rapid recovery of real output and a shift to a new, noninflationary future, is worth a try.