Nominal GDP, the flow of money expenditures on current output, is approximately 14 percent below the growth path of the Great Moderation. The norm of nominal GDP growth path targeting implies that this was an error and it should have been prevented or reversed long ago. However, the Fed has yet to adopt the norm. Given where we are today, what should be done? What is the appropriate growth path for nominal GDP?
The recent proposal from Goldman-Sachs includes a growth path that apparently was generated by starting at the growth path of the Great Moderation at the end of 2007 and then lowing the growth rate from 5.4 percent to 4.5 percent. Presumably this is the sum of a trend inflation rate of 2 percent and estimates of the growth rate of potential output over the last decade of 2.5%. During the Great Moderation, the trend growth rate of potential output was 3 percent, and the growth rate of nominal GDP of 5.4 percent resulting in an inflation rate of 2.4 percent as measured by the GDP deflator.
The Goldman Trend is shown in green below.
The current level of the Goldman-Sachs alternative is $16,905 billion and the current value of nominal GDP, $15,198.6 is 10.1 percent below. The usual Market Monetarist approach is to specify a target one year in the future, so the target for the third quarter of 2012 is $17,679 billion. To reach that level in one year, the growth rate of nominal GDP would need to be 16.3 percent.
The target for two years into the future, for the third quarter of 2013 is $18,488 billion. The annual growth rate of nominal GDP from its current value to that level two years from now would be 10.83 percent. Reaching the new growth path over two years suggests a target for next third quarter of 2012 of $16,824 billion.
While 11 percent nominal GDP is quite high, the annual growth rate of nominal GDP for each quarter from the second quarter of 1983 to the second quarter of 1984 was over 10 percent. If Reagan and Volker could manage it, certainly it is possible.
In a previous post, I had suggested that the Fed copy Reagan/Volcker and target nominal GDP growth for the next two years identical to that of 1983 and 1984. In the last few days, I thought of a slightly different approach. Rather than start now, instead, suppose that the Reagan/Volker growth rates had occurred at the trough of the Great Recession, the second quarter of 2009. Nominal GDP is now 10.7 percent below that growth path. If the new growth rate were 4.5 percent, then the similarity to the proposed Goldman-Sachs alternative is striking.
In the diagram below, nominal GDP is represented in blue. The growth path of the Great Moderation is in red. The Goldman-Sachs alternative is in green. If the growth rate of nominal GDP had matched that from 1983 and 1984 from the second quarter of 2009, the resulting "Reagan/Volcker" growth path is shown in black. The dashed line shows a two year adjustment growth path. The growth rate for those two years would be 10.7 percent.
The difference between the Goldman Sachs and Reagan Volcker alternatives is so small, it hardly makes a difference. It is pretty much the situation that Goldman Sachs proposed a new growth path that approximates what would have happened if Obama and Bernanke had done their job as well as Reagan and Volcker. All I can say is--better late than never.